Signs that inflation and interest rates are set to rise may not herald the gloomy prospects for property feared by some
Inflation is back. Last month US inflation rose to 4.69%, exceeding the 10-year US Treasury yield for the first time since 1973. Central bankers are either raising rates or talking tough about doing so. Yet long-term interest rates have only moved marginally and the yield curve has flattened. While this has been favourable for property, everyone is now worrying whether the yield curve will steepen and hence whether current pricing levels are sustainable.
History tells us that inflation risk has not always been rife. It has tended to come in bouts between long periods of price stability. Its appearance is usually correlated with a war, as major wars tend to destroy capacity and capital, making things scarce and pushing up prices.
The 1970s inflationary period was caused by the design of the post-World War Two global financial system and wars in south-east Asia, leading to oversupply of the dollar in the late 1960s, ultimately resulting in a major dollar devaluation. At the same time OPEC induced a “supply side” shock, cutting oil production and driving up oil prices.
What made the 1970s so different was the speed with which price rises translated to wages, creating spiralling inflation. This was a result of the rigidity of organised labour; thirty years on things have changed, albeit not enough in some countries to lay the spectre of 1970s-style inflation to rest.
There are similarities between today and 1973: we have high oil prices, unrest in the Middle East and the Chinese Yuan pegged to the dollar. But none of the policy challenges are as tough as they were in the 1970s. The old link between prices and wages in the west has been weakened. This may have anchored inflation expectations, which is good news, as it implies inflation “shocks” are less likely to lead to persistent price rises.
The ECB is making hawkish noises and interest rates are likely to rise. But the bond markets rightly believe inflation risks are low, and since growth is modest, any rise in short rates leads to a decrease in long rates and a flattening of the yield curve. This helps boost asset prices, particularly for property.
Three options for the ECB
The ECB has three options. It could talk tough but be gentle, only raising rates modestly, allowing growth to gather momentum and accepting that inflation is above target, but that it is unlikely to spread to wages; if we are correct, the yield curve would steepen, but not much. Or it could talk tough and act tough; raise rates to fight inflation and accept an economic slowdown in the knowledge that the yield curve will flatten out in the long term. The third option is to “go nuclear”; raise rates dramatically to kill off consumer and asset price inflation by enforcing a recession.
The first two options are both broadly positive for property. A sane central banker could not contemplate option three, as the euro would struggle to survive.
History suggests that a flatter yield curve is not all that unusual. Typically the long/short spread was narrower than the 200+ basis point gap that has prevailed for much of the past 40 years; in fact in France, the spread has averaged just under 100 basis points since 1800. Perhaps even more interestingly, since 1840, the average UK spread has been zero.
If flatter yield curves are sustainable over time then asset price adjustments are not bubbles, but rather a natural function of the shift from an era of uncontrollable inflation to a world where prices are somewhat more predictable.
Simon Martin is head of investment strategy and research at Curzon Global Partners
| Heard in the Eurolounge
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