Governments and Central Banks worldwide have been responding to the Coronavirus pandemic with unprecedented measures to soften the effects of the economic contraction by rolling out record fiscal stimulus and decreasing policy rates to historically low levels. As a result, the International Monetary Fund (IMF) now forecasts that global public debt at the end of 2020 will reach an alltime high of 101.5% of GDP, up 19 percentage points from 2019. With the majority of stimulus financing coming from increased government borrowing, this has sparked concerns that the resulting deluge of global debt issuance will ultimately push interest rates much higher and consequently tighten global financial conditions, threatening the economic recovery. As government entities cannot allow this to happen, Central Banks worldwide have been as aggressive as ever in expanding their balance sheets and purchasing a wide variety of financial assets including federal, provincial and corporate bonds in Canada in order to prevent rates from rising. Central Bank purchases of financial assets, popularly known as quantitative easing, have historically proved an effective tool for financing increased government borrowings and keeping interest rates low, since the ability to attract enough capital to finance large deficits when interest rates are historically low is limited.
We are of the view that the whatever-it-takes strategy adopted so far by governments and Central Banks worldwide is likely to result in higher market-based inflation expectations and consequently, higher bond yields in the near term. The rationale is that due to the resulting decline in borrowing costs and increased wealth through holdings of financial assets (where prices are pushed higher by quantitative easing programs), consumers should increase personal spending and businesses should feel more comfortable in increasing capital spending, thereby improving employment and stimulating economic growth. Because of the improving macroeconomic backdrop, individuals, businesses and investors should anticipate higher prices in the future, thus pushing inflation expectations and bond yields higher. Also contributing to the increase in market-based inflation expectations is the historical shift by the Federal Reserve in how it sets interest rates. In late August, the Federal Reserve announced that it would now seek to achieve inflation that averages 2% over time, which implies that following periods when inflation has been running below 2%, the monetary policy will aim for inflation moderately above 2% for some time. Expect the Bank of Canada to adopt a similar stance over the next few months. This newly announced flexible average inflation targeting strategy is particularly relevant since inflation has indeed stayed persistently below the 2% target for most of the past ten years. In other words, this new approach means that the Federal Reserve will be more inclined to allow inflation to run higher before hiking short-term rates or ending quantitative easing programs, which should push inflation expectations higher.
On the other hand, we are also of the view that near-term increases in medium- and long-term interest rates due to rising inflation expectations are likely to remain quite limited. Indeed, the likelihood that Central Banks worldwide will have to continue to engage in sizable purchases of financial assets in order to prevent yields from rising too much as the global economy recovers is very high. The rising amount of debt in the world economy makes global economic growth more and more vulnerable to a tightening in financial conditions. The past forty years effectively taught us that significant increases in bond yields historically resulted in economic or financial shocks, with the tightening in borrowing conditions choking economic growth. The 1990-1991 recession, the 1997 Asian financial crisis, the 2000 dot-com bubble burst and the financial crisis of 2007-2008 all illustrate this point. As economic prospects consequently deteriorated, bond yields finally returned to their long-term structural downward trend that started in the early 80s. In other words, global interest rates have to stay low so that debt service costs remain manageable for governments, corporations and individuals, even on very large and rising debt levels. This should effectively encourage Central Banks worldwide to maintain very accommodative financial conditions for a protracted period, putting a cap on future increases in rates.
The big question now is: will these very accommodative policies ultimately lead to a surge in inflationary pressures and consequently push central bankers to change their strategy? Gold is widely considered an inflationary hedge and its recent surge could provide indication that such a scenario concerns more and more investors. In our view, technological advancements, the sharing economy, the adoption of global supply chains and greater capital and investment flows across countries should continue to reduce costs of production and put downward pressure on prices in the near future. There are also rising expectations that the Coronavirus pandemic will boost ecommerce in the end, which implies greater price transparency and more competition among businesses, thus limiting the potential for a surge in inflationary pressures. Finally, the rising adoption of remote work following this pandemic could also curb inflation, leading companies to rethink salaries and compensation, adding downward pressure on cost structure and creating a global competition for talent. The bottom line is that structural factors should continue to prevent a surge in inflationary pressures in the near term, which suggests that the low interest rate environment is here to stay for a long time.
Eric Corbeil, MSc, CFA, FRM
Mutual Fund Investment Specialist
Credential Asset Mangement Inc.
Caisse Alliance – Kapuskasing Branch
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