Bond market plummets due to high inflation

High inflation is not only affecting our purchasing power. Losses are also mounting in the bond market. Due to the rise in interest rates, bond prices have already fallen by 11% since the beginning of last year, the Largest drop since 1990. Converted to dollars, $2.6 trillion in value has already evaporated from the bond market since January 2021. By comparison, that's more the drop of about $2 trillion during the 2008 credit crisis.

Bond prices fall when interest rates rise, because existing bonds issued with lower interest rates become less attractive. In recent years, interest rates have fallen, causing bond prices to rise to record highs. But now that interest rates are rising again, those prices are falling again, especially for bonds with longer maturities. A long term means that as an investor you are stuck with a relatively low return for a long time. For example, the prices of government bonds with a maturity of a hundred years have already more than halved in value.

Bond prices under pressure due to rising interest rates (Source: Bloomberg)

Interest rates up due to high inflation

Inflation started to rise in the second half of last year due to logistical problems and shortages of certain raw materials. On top of that, there are the effects of the war in Ukraine, such as the Price increases of oil, gas and other raw materials. As a result, inflation has not fallen, but has risen further. It is therefore not surprising that investors are now charging a higher interest rate for money they lend to governments and companies.

The US 10-year yield is already at 2,35%, while at the beginning of 2021 it was still around 1%. In the same period, the interest rate on a German government loan with the same maturity rose from -0.5% to +0,58%. These rates are still well below inflation, but the rapid rise in interest rates is making investors nervous. If inflation remains high, interest rates will rise further and put further pressure on bond prices. In other words, the downside potential of bonds for investors is many times greater than the upside potential.

Austrian 100-year government bond has almost halved in value

Is a new recession imminent?

One of the most reliable indicators of a recession is an inverted yield curve. This is the case if the interest rate on short-term government bonds is higher than that on longer-dated debt. This could happen at a time when financial markets are becoming more uncertain about the future.

Since the beginning of this century, there have been three inverted yield curves in the United States, namely in February 2000, December 2005 and August 2019. The first two were accompanied by a major economic crisis, the latter by problems in the repo market. All three were also accompanied by a cycle of interest rate hikes by the U.S. central bank, the Federal Reserve.

We previously saw an inverted yield curve in 2000, 2005 and 2019 (Source: Bloomberg)

Are bonds still a safe haven?

Normally, bonds perform well when stock prices are under pressure and uncertainty in financial markets increases. But that's not happening now. Rising interest rates are depreciating bonds, especially those with longer maturities. As an investor, you add more risk than return to the investment portfolio with bonds. The prospect of central banks raising interest rates doesn't exactly help.

Today, a traditional investment portfolio with only stocks and bonds is no longer sufficient to hedge risks. We already saw this during the corona crisis and we are seeing it again now with the war in Ukraine. This year, the prices of both stocks and bonds have fallen. So, investors need to look beyond this traditional portfolio and review their investment strategy. Gold turned out to be a good Hedge during the corona crisis and got off to a strong start again this year. Since the beginning of this year, the gold price in euros has risen by more than 11%. Is gold the better safe haven?

This contribution comes from Geotrendlines

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On behalf of Holland Gold, Paul Buitink and Joris Beemsterboer interview various economists and experts in the field of macroeconomics. The aim of the podcast is to provide the viewer with a better picture and guidance in an increasingly rapidly changing macroeconomic and monetary landscape. Click here  to subscribe.