Bond markets are giving strong signals to central banks that their attempts to restore the economy by solely pushing more and more money may be putting the world economy into another type of dangerous situation. From fears of deflation in last march to the fears of inflation this march, the things have changed drastically in the way economy stands out. The massive liquidity push by central banks like Fed, RBI was meant to keep the economy float but it seems that central banks wanted to do more. So, they decided that they will resurrect the economy through their prowess of quantitative easing. Low lending rates meant that every asset class except fixed income became underpriced and thus, investors rushed to purchase assets to grab the opportunity. No doubt, the ones who took the risk and rode the monetary tide surely have benefitted but how far this will be sustained only future can tell.

However, first side-effects of central banks huge money-pumping exercise are visible now. There is a massive sell-off in the bond market as the investors feel that existing coupon rates are not enough to compensate for the inflation expectations of the future. And they are not wrong. Metals are at record highs, stock markets are at record highs, oil is reaching elevated level then why fixed income should not get better yields. From here, only two things are possible either the Bond market will be dead i.e. no one will invest in government bonds or the yields have to go up. The later has a higher probability to happen as bond market is the preferred habitat for many pension funds who will fail to deliver returns which will affect many senior citizens. Thus, there is a high likelihood that interest rates may again start to pick up.

Now what can happen if interest rates pick up? Interest rate will automatically make other asset classes like markets , commodities and fuel cheaper than what they are. While these asset classes will remain attractive but they will definitely get normalized than current overvaluation. But major risk will be the interest rate trap in which many retail customers who are right now investing in long-term assets like housing due to low interest rates may suddenly see their loan repayments rising due to increase in interest rates. Most of the long-term loans have floating interest rates and are likely to get affected by this. Imagine, a 200 basis points rise can increase the interest payments to as much as 130% of the earlier interest payments. And this is not a figment of imagination. Before Covid, home loan rates in India were around 8.7 percent and now they are 6.7 percent, 200 basis points drop and a rebound to earlier level is possible.

Low interest rate regimes can sustain in deflationary environment but not in inflationary environment and it thus appears that strong growth forecast will definitely bring inflation back. To be very sure, inflation is not bad from employment angle. High inflation also indicates low unemployment rate and thus, fed’s task of providing full employment rate is commensurate with its task of raising inflation. But inflation will also impact public finances which are now totally on leverage. As the bond yields rise, governments will struggle to repay the loans and service their debts. Further, borrowing costs for governments will also increase. Last two auctions of RBI bonds resulted in failure. IRFC, a premium high rated NBFC failed to raise debt at current yields. Further, it will also reduce the room of government spending as governments struggle to raise cheap money. It clearly shows that market is not ready to get so low returns when inflationary pressures are building up.

Now the only hope we have is growth. Will the economies experience the growth rate which will be sufficiently higher to cover the higher interest costs? This a million dollar question as economic growth is complex combination of micro and macro factors where many things have to fall in place to sustain high growth rates for years to come. The productivity will have to improve, consumption has to be sustained, demand and supply has to pick up. The indicators regarding this remain mixed as apart from some big corporations, largely the economy is struggling to pick up to full steam. Fed and central banks have gone too far in creating a situation where if growth does not pick up, the economies may struggle in stagnation for years to come. It is a casino situation of all-in where central banks have put so much on the table that rather than cutting the earlier losses it has developed a high risk game where consequences are high. In all these happenings, a major learning for finance is that it can save a thing, sustain a thing but if in its over enthusiasm it wants to create a thing, then it may be taking on risk for which it may not have the appetite. The Fed’s attempt to save economy was proper and in time but its attempt to overuse its monetary tool may just boomerang if not tapered down in time.