Bond markets set for a taste of the 60s as inflation picks up

By Dhara Ranasinghe

LONDON (Reuters) - Inflation has a habit of creeping up on you. Just ask historians.

From rates below zero less than a year ago, inflation across the developed world has risen in recent months towards central bank targets, largely driven by a rising oil price.

And if history is any guide, bond markets had better beware.

Paul Schmelzing, a visiting scholar at the Bank of England from Harvard University, has studied 800 years of bond markets history and says the most relevant parallel with today's environment is with the late 1960s under U.S. President Richard Nixon.

The United States was emerging from a prolonged period of low inflation, the jobs market was tightening and a new pro-business president had raised expectations of fiscal expansion. It was a bruising time for bond investors.

U.S. bonds lost 36 percent in real price terms between 1965 and 1970, while annual consumer price inflation more than tripled in the period, to 5.9 percent from 1.6 percent.

As the world's biggest bond market, what happens to U.S. Treasuries usually sets the tone for bonds across the world.

The spectre of what Schmelzing describes as an "inflation reversal" could be the final nail in the coffin of a 36-year bull run in government bonds that has been underpinned by years of low growth and subdued inflationary pressures.

"If you look at inflation expectations in the 1960s, no one expected them to rise so quickly but inflation can accelerate quickly and take people by surprise," said Schmelzing.

Based on historical standards, bonds could be set for double-digit losses, he said.

Other elements of previous sell-offs are also coming into play, creating the potential for a "perfect storm" for fixed income assets, he added.

This includes a sudden steepening in yield curves, as witnessed in a sharp sell-off in Japan in 2003.

END OF AN ERA?

Bond yields globally have risen recently on Trump "reflation" bets and growing signs of strength in the global economy.

U.S 10-year yields have risen about 65 basis points since the November election to around 2.50 percent, and German Bund yields -- the euro zone benchmark -- are near one-year highs just under 0.50 percent.

Based on his analysis of bond bear markets, Schmelzing said that what is currently priced into market inflation expectations may be conservative.

A sharp jump in yields on signs that inflation is taking off could be painful for bond investors and hurt savers.

The interest rate on benchmark Bunds, for instance, is just 0.25 percent, so even a slight rise in yield can outweigh an investor's return and spark a snowballing sell-off.

The 2015 "Bund tantrum" provided a taste of what happens when investors sense inflation building -- German yields rose sharply from record lows as data pointed to an inflation uptick.

What that episode showed, said Schmelzing, is that inflation remains the key driver for bond markets. But what is different to 2015 is that the uptick in inflation appears more enduring.

U.S. average hourly earnings rose 2.9 percent in December, the largest year-on-year increase since 2009, and Germany's unemployment rate is at its lowest level since reunification in 1990 -- suggesting the jobs market in Europe's biggest economy is tightening.

China's producer prices surged the most in more than five years in December, while in the UK, many economists expect inflation will hit 3 percent later this year -- well above the Bank of England's 2 percent target.

"What is changing is that we are no longer looking at economies with a lot of slack in them," said Lombard chief economist Charles Dumas.

Pictet estimates annual returns in the next 10 years from U.S. Treasuries could be less than half the 4.8 percent of the past 10 years, while German Bunds, will on average deliver negative returns.

For some investors, there is now a clear risk from the trajectory for higher interest rates.

"The risk is greater for bond holders about rising interest rates now than at any point since the financial crisis," said Payson Swaffield, Chief Income Investment Officer at Eaton Vance, an asset management firm with $354 billion in assets. "There will be periods where we will question that, but I believe the landscape has changed."

(Additional reporting by Jamie McGeever, graphic by Nigel Stephenson; Editing by Toby Chopra)