How to not get battered

US interest rates have been drifting upwards since mid-2020, but over the past few weeks, interest rates have skyrocketed. For instance, US 2-year interest rates rose from around 0.13 per cent at the beginning of 2021 to around 2.29 per cent in March 2022, while US 10-year interest rates went up from 0.91 per cent to 2.33 per cent in the same period. Of course, from a long-term perspective, US credit costs are still relatively low. However, the impact of such a move on bond prices is wild. To give an example: due to a rise in the market yield from 1 per cent to 2 per cent, the price of a 1 per cent coupon-bearing bond with a maturity of 10 years would decline by around 17 per cent.

Deflating bond prices, of course, is just one effect higher interest rates will have. After many years of ultra-low interest rates, the economies‘ production and employment structure depend on a continued low yield environment more than ever. While slightly higher interest rates will not necessarily upset economic expansion, the critical question is: at what point will higher credit costs trigger a bust? Neither the Federal Reserve (Fed) nor any other central bank, economist, politician, or businessman would know. The truth is that the Fed and other central banks are pursuing a “trial and error” process when it comes to raising borrowing costs.

To make matters even more uncomfortable, the recent string of very high rates of consumer goods price inflation is urging monetary policymakers to accelerate tightening, and more aggressively so than previously intended. On the one hand, this is understandable: With US CPI inflation close to 8 per cent in February 2022, US short term interest rates are still close to a record low of minus 7.65 per cent in real terms; in Germany, the inflation-adjusted short-term interest rate is around minus 6.3 per cent. On the other hand, faster and more aggressive tightening of monetary policy increases the likelihood of something going wrong; that, shall we say, the economies fall over the cliff.

The pressing question is: how serious are central banks about containing inflation? There is no doubt that some political circles take a positive view of elevated inflation. For example, higher inflation reduces governments’ real debt burden, and under a system of progressive income taxes, inflation increasingly transfers resources from the private sector into the state’s coffers. As long as people are not complaining too loudly, however, inflationary policies can continue. What is more, inflationary policies can go on for quite some time if people do not understand the real cause of inflation – and that is the increase in the quantity of money created by central banks. 

Take the current situation, for instance. The rise in inflation is, in fact, being attributed to rising energy costs, supply-side constraints caused by “lockdowns”, and, most importantly, Russia’s war against Ukraine. While all these factors can and do contribute to raising some goods prices, it is actually central banks‘ drastic increase in the quantity of money that makes the „negative goods price shocks“ translate into inflation – i.e. a sustained rise in goods prices across the board. If the general public believes that „extraordinary factors“ beyond central bank control are the cause of inflation, then monetary policymakers may well continue with their inflation policy for longer.

As we have pointed out in previous reports, we remain sceptical that central banks mean business when it comes to reducing inflation. Of course, they will continue to raise interest rates somewhat. But they are unlikely to be able to raise interest rates to a level that sufficiently reduces money supply growth and brings inflation back to around 2 per cent for the foreseeable future. From this perspective, elevated inflation is very likely here to stay. At the same time, central banks will do their best to maintain market expectations that the tightening cycle has just begun, lest inflation expectations spiral out of control. 

A lot can go wrong along this path. As noted earlier, policymakers could inadvertently crush the economies. Or the series of „negative price shocks“ will continue, further dramatizing the already serious inflation problem and eventually forcing central banks to trigger a deep recession to curb inflation. Against this backdrop of quite unfavourable scenarios, the investor might ask: how not to get battered? If one agrees that elevated inflation will persist and that central banks are unlikely to bring real interest rates back into positive territory, keeping money balances and bonds (buy-and-hold) would not be prudent. What about stocks then?

Times of high inflation tend to be difficult for many firms. However, some of them (but unfortunately not all!) should be able to weather even an „inflationary storm“. And as long as real interest rates remain below zero, monetary conditions should remain favourable for stock markets. What is more, holding physical gold and silver is also an option for the investor seeking protection against inflation and the economic as well as political discontinuities it may cause. In other words, to avoid getting battered by inflation, you should have at least some physical gold and silver in your portfolio. This is not the only possible remedy, but it is a timetested escape route when the debasement of the purchasing power of official currencies is gaining momentum.

Thorsten Polleit, Chief Economist of Degussa