Inflation’s first casualties brace for worse to come

Bill Gross, the one time leader of PIMCO, made the call only last month that the most recent ‘bond rally’ was the last hurrah. Picture: Bloomberg

For shoppers higher inflation means higher prices, for workers it means weaker purchasing power, but the first casualties of inflation are going to be bond market investors.

The latest inflation uptick will be felt most keenly among a new generation of first-time investors who have recently entered the market through exchange traded funds.

It has been a long time since the bond markets let investors down, in fact the last time that bonds were a loss-making proposition was so long ago that few investors would remember.

During what may soon look like the golden age for bond returns, yields fell from more than 15 per cent to zero. With every major step down in that 40-year sloping graph of yields came a lift in prices and a pick up in total returns for investors.

But in recent weeks a reckoning – temporarily postponed by the Covid crisis – now looks very likely to be underway. The pressure on bond returns is mounting across global markets and even in our own backyard this week’s inflation reading saw “core inflation” move higher than the Reserve Bank had expected.

For millions of Australians who have tiptoed into the fixed interest market – particularly retirees chasing yield and diversification – a key test now awaits.

On basic logic it is looking like the only way for bond yields to move is higher and that means prices and total returns could be negative until we return to something like a new normal.

Apart from the obvious matter that bond yields have little room left to drop, we have had major global stimulus program which must now be steadily unwound along with an energy supply crisis in the northern hemisphere.

Importantly, many professionals in the bond market know that good returns in recent times came from an unexpected Covid-crisis drop in yields – when that happened the total returns remained positive but they were sustained by a surprise lift in bond prices.

One of the world’s best known bond market investors, Bill Gross, the one time leader of PIMCO, made the call only last month that the most recent “bond rally” was the last hurrah, describing bonds as “trash” in his newsletter and warning that US government debt would be a losing bet.

The losses to date for retail investors have been modest. But such losses have to be viewed first as a historic shock and more importantly as a potential signal of what might be coming.

The global Bloomberg Multiverse bond index is down more than 4 per cent this year and is on its way to the worst performance in 17 years.

Among big ETFs linked with bond indices the losses have begun. Popular fixed income products from Vanguard have lost money – the Vanguard Australian Fixed Interest Index ETF has a one-year total return of -1.72 per cent, and the Vanguard Australian Government Bond Index has a one-year return of -2.16 per cent.

One layer below the ETFs are the actual bonds themselves which are down across the board: Australian bonds are down 1.5 per cent in the year to September while global bonds are down 0.8 per cent.

Around the world bond yields and have been steadily rising against a backdrop of a global recovery. In Australia the situation is more stable – that stability comes from the Reserve Bank working hard behind the scenes to keep rates lower for longer – but we now have some early signs which suggest that policy is coming under pressure.