06 Oct Guest Commentary – Gord Glagau, Economist: Protecting against Inflation (Sept 12 2020)
“If the fiscal and monetary authorities won’t regulate the economy, the bond vigilantes will.” In 1984, economist Ed Yardeni coined a term, bond market vigilantes, in response to the #1 issue of the day – large fiscal deficits in the US. The recession, tax cuts, the ramp-up of Cold War military spending and higher social spending combined to produce record deficits. Reluctant to raise taxes, the Reagan Administration argued that growth would solve the deficit problem and this was echoed by the Bush Administration.
In a famous 1988 speech by the Republican presidential candidate (soon to be president), George H. W. Bush boldly stated, “Read my lips: no new taxes”. Bush ended up as a one-term president mostly because he broke that promise and raised taxes. Bush’s predecessor, Bill Clinton, faced with yet more red ink, raised taxes even further.
History would say that both Bush and Clinton had no choice; the bond market vigilantes had forced their hand. From late 1993 through 1994, these fiscal deficits scared bond investors and produced the “Great Bond Massacre”. The benchmark 10-year bond yield surged from 5.2% to over 8.0%. Recall that interest rates are primarily set by the bond market as a function of bond prices. When bond investors see danger, they sell. This selling puts downward pressure on prices and raises yields.
Clinton got it right by producing a balanced budget through fiscal discipline, leading to lower interest rates, which in turn encouraged private-sector investment. Public debt relative to the size of the US economy fell from 47.8% in 1993 to 31.4% in 2001. Lower public debt combined with lower interest rates produced a windfall and ushered in one of the greatest periods of economic growth in US history.
The story is similar in Canada. Paul Martin was named Finance Minister in 1993 during a time when Canada had one of the highest budget deficits of the G7 economies. Bond-rating agencies downgraded Canada reflecting this growing public debt. Martin could see the debt spiral unfold – higher debt would lead to higher interest rates leading to an exponential growth of debt servicing costs. His response was to bring in massive budget cuts and by 1998 tabled a balanced budget and saw Canada’s bond rating restored to AAA, the highest quality rating.
Fast-forward to today. This year alone, Canada is on track for a $343 billion deficit. That is a staggering number and raises the federal debt to the size of the economy to 49% from 31% last year. Remember that this is the level which triggered the Great Bond Massacre in the US.
Some would say that it is different this time – central banks have intervened in an unprecedented way. You may have heard of “quantitative easing”, which has been somewhat in vogue since the Great Recession of 2008. In order to explain how this works, let me first summarize (and simplify) how monetary policy in general works.
Central banks target a lower interest rate (typically on the overnight rate) by buying short-term instruments. This buying drives up prices and lowers yields. The central bank pays for these bond purchases by issuing money, either physical cash or by depositing money into the financial system. The supply of money is defined as money that is in circulation outside of the central bank – most commonly held in the form of cash and bank deposits. As banks receive these deposits, they are able to lend more and that lending becomes the deposit of another, and so on. As long as the banks keep lending against these additional deposits, there will be a multiplier effect. One dollar of central bank bond purchases translates to an increase of many dollars in the economy.
Quantitative easing is where a central bank engages in aggressive buying across all debt maturities, not just affecting short-term interest rates (which is the usual policy tool), but longer maturities as well. In this world, governments run deficits, financed by newly issued debt which the central bank then purchases. The thinking is that not only do the government purchases of goods and services help increase economic activity, but the multiplier effect from the central bank buying this new debt adds an additional boost as well. Case in point: the Bank of Canada’s balance sheet typically has assets of $100 billion. To finance the massive deficit in 2020, the Bank of Canada’s balance sheet swelled to over $500 billion in a matter of a few months. Arguably, the Canadian economy is awash in cash.
In addition to budget deficits, another enemy of the bond market is inflation, because it erodes the purchasing power of a bond’s cash flows. Simply put, inflation is caused by more money chasing fewer goods and services. The mandated shut-downs due to COVID have produced a significant decline in the real economy – fewer cars, haircuts and restaurant meals have been produced. And, we’ve already discussed how quantitative easing has increased the money supply. Put these together and the conditions couldn’t be better for a resurgence of inflation.
So, for those investors out there looking for safety, the bond market (even high-quality government debt) may be at risk. Buying a US 10-yr bond that currently yields 0.67% (that same bond yields 0.55% in Canada) leaves the door wide open to significant capital losses should inflation rise. The answer lies in a category of bonds that are linked to inflation. Treasury Inflation Protected Securities (TIPS) in the US and Real Return Bonds (RRBs) in Canada pay interest and principal adjusted by inflation. And to make these investments even more accessible to the retail investor, Exchange Traded Funds (ETFs) exist. For a US bond investor, consider ticker symbol TIP, a $US bond ETF with inflation protection. In Canada, BlackRock markets a $CAD real return bond ETF (ticker symbol XRB).