Are the bond vigilantes vigilant enough?

On the day that the Bank of England started its Quantitative Easing (QE) regime with the purchase of £340 million of commercial paper under the Asset Purchase Facility, it’s worth remembering why our blog is called Bond Vigilantes, and ask ourselves whether we need to be baring our teeth a little more.

The term Bond Vigilantes dates from the bond market’s aggressive response to President Clinton’s attempt to increase the US budget deficit in the 1990s. The Treasury Bond market selloff (leading to rising financing costs for the US) helped to persuade the administration to balance the budget.  Clinton’s political adviser at the time, James Carville noted “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter*. But now I would like to come back as the bond market. You can intimidate everybody”.

I would want to come back as Brad Pitt.

Well, with the collapse of the global economy, budget deficits everywhere in the world have been allowed to expand to almost unheard of levels.  Government borrowing in the UK will be about 8% of GDP in the next year, the highest in recent history (it hit 7.7% in 1993-94) and our debt to GDP level is quickly heading north of 50%.  The Office of National Statistics has declared that the liabilities of the nationalised and part-nationalised UK banks will have to be added to the UK’s balance sheet, so we could be nearing 100% pretty imminently.  At the same time, the Bank of England is starting to print money and central banks everywhere have added to the government’s fiscal stimulus packages with a huge amount of monetary easing (zero interest rate policies).  All of this should, on the face of it, be really bad news for investors in government bonds.  Fears of a never-ending supply of government bonds, and stories that hyperinflation is on its way, have made many bond investors fearful.

So a good bond vigilante really needs to take a step back from the consensus view that we are going to see a year of weak inflation (perhaps with a period of mild deflation) and then there’s a chance that it’s Zimbabwe here we come.  So what are the theoretical drivers of inflation, and is it possible that the consensus could be very wrong this time?

Are you a monetarist or a Keynesian? Monetarist Milton Friedman popularised what is known as the Quantity Theory of Money. In short, the theory simply reflects the idea that if you print more money, the value of that money is reduced proportionately to the amount of money printed.  The equation he used was MV = PQ, where M is the amount of money in circulation, V is the velocity of money, P is the price level and Q is the total number of items purchased with the money in circulation. The important thing to note is that there is more than one determinant in the generation of inflation in the economy – the quantity of money is very important, but a rise in this quantity can be offset by a fall in the velocity of money. If money stops moving around the economy (because individuals, banks, and companies are hoarding it) then printing the stuff won’t generate inflation. This spreadsheet here allows you to plug in some numbers of your own to estimate what might happen going forwards – I’m using column C, which allows you to input all factors other than inflation. Thinking about the last year, let’s say that the broad money supply grew by 17.5% (M4), the velocity of money remained unchanged, and the quantity of goods sold rose by 4.3% (volume of retail sales). This results in annual inflation of 12.66%, but UK CPI in 2008 ended at 3.1%. What change in the velocity of money would therefore result in the actual inflation rate? The answer is that a fall in the velocity of money from 5 to 4.575 results in inflation of 3.1%. This is a slowing in the speed of money going around the economy of 8.5%. Assuming that the other factors remained the same, a decline in the velocity of money of 11% would have lead to zero inflation, and anything greater to outright deflation. It therefore follows that even printing money, and doing Ben Bernanke style helicopter drops of dollar bills over the population can’t generate inflation unless we go and do something with that cash.

For the Keynesians, I present the output gap theory.  The output gap is the difference between the potential growth in an economy (based on factors like demographic growth in the labour market and productivity improvements) and the actual growth.  When an economy is growing below trend, it is difficult to generate inflation – too many out of work employees are chasing too few vacancies, and wage growth is stifled.  Unused factory capacity, high stocks of inventories, going out of business sales and empty buildings also keep the lid on inflation.  Our favourite economist, Paul Krugman published this analysis of the US output gap and its impact on inflation on his NY Times blog a couple of weeks ago (thanks to David Parkinson of RBC for the link).  You can see that for every 1% that actual growth falls below potential growth, the inflation rate is reduced by 0.5%.  The US Congressional Budget Office is saying that the output gap will be 6.8% over the next two years, which means that the US is staring at a period of deflation, even if you assume that President Obama’s fiscal stimulus fills in a third to half of that growth shortfall.

Finally, thinking back to the UK’s last period of fiscal indiscipline – the 1993 budget deficit of 7.7% – did the gilt market collapse?  Well no.  10 year gilt yields fell from 9.7% to 6.1% – a gigantic rally.  A selloff did come, but not until the next year, when the Fed hiked rates – something clearly (and explicitly) not on the cards for some time to come.  Vigilant yes, panicked, no.

* Note for non-US readers, I believe that .400 is a good batting average in a version of the game that we know as rounders.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

Jim Leaviss

Job Title: CIO Public Fixed Income

Specialist Subjects: Macro economics and fixed interest asset allocation

Likes: Cycling, factory records, dim sum

Heroes: Brian Clough, Morrissey, Neil Armstrong

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