Bond markets react to inflation report

With the Bank of England's Quarterly Inflation Report talking about a fall in the headline inflation rate in the medium term and a significant snap-back in the oil price, bond markets were quick to price in two, possibly three, rate cuts in the next 12 months.

According to Adam Mossakowski, credit fund manager assisting Fatima Luis on the F&C Extra Income and Strategic Bond funds, it seems concerns over inflation, stagflation and a growth-strangling commodity super-cycle have abated. However, Mossakowski warns about the danger of the other face of monetary instability: deflation.

"Deflation has a devastating dual-effect. Firstly, it constricts economic activity. Why buy something today when you can buy it cheaper tomorrow? Secondly, it increases the debt burden," he explained. While inflation will over time erode the principal owed, deflation has the opposite effect. If prices are falling at 5% and official rates are zero then the real interest rate is still a positive 5%. If all you do is service debt without paying any principal off, the amount owed will become 5% more onerous each year.

The last time markets witnessed deflation on a meaningful scale was during the US Depression of the 1930s and, latterly, post the bursting of the Japanese bubble economy. Indeed, Japan is still suffering from deflationary forces and has only recently seen its headline rate rise meaningfully above 0%.

"But what spooked bond markets late last year and to some extent now, are that both these periods were preceded by an expansion in growth fuelled by an overabundance of cheap debt," he said. "In the run up to the 1929 stock market crash, financial speculation was rife. Then, as now, the corporate share of GDP was at historic highs, indebtedness, particularly in the household sector, was rising and commodity prices were on the up."

The ‘Roaring 20s' were a decade funded by debt. But then came bust. The 1930s were mired by bank failures and defaults. It was not long before spending and investment retrenched enough to see prices deflate.

"Similarly in Japan, the late 1980s were financed by a speculative boom in equity prices and ever-cheap debt. Shares traded on ludicrous P/E ratios and the value of property, on which the majority of Japanese debt was secured, rose to astronomical levels," he said.

But the similarities between those two periods and today probably end there. "The official response in both 1930s America and 1990s Japan was to initially tighten policy. Fast-forward to today and we see a coordinated response from central banks in the form of sizeable liquidity injections as well as, in many cases, lower rates."

"So while the backdrop behind today's troubles might look now as it did then, policy makers have the benefit of past experience on which to base their responses. Couple that with claims from proponents of the commodity super-cycle that we are just in the beginning of such a phase and deflation looks anything but a certainty," he said.