Bond market faces risk from global inflation trends

The Federal Open Market Committee (FOMC) on April 30 delivered a 25 basis point cut in the Fed Funds rates. Before cutting interest rate aggressively from 5.25 per cent to 2 per cent (bringing US rates to the lowest amongst G-7 nations), criticism had already been mounting whether such a policy stance was helping or hurting the US economy.

Cutting interest rates meant more supplies of US dollars in financial markets and, like any commodity, the more supply for a given demand will cause its price to fall. To hedge against the depreciating dollar, investors sought shelter in commodities. Such a phenomenon is indicative that investors are losing faith in "fiat" money, that is, money backed by the government's credit rather than precious metals like gold. The combination of a declining US dollar and rising commodity prices helped to keep US inflation elevated, north of 4 per cent. Many now argue that the Fed's actions have eroded US consumers' disposable income and will accelerate the pace of the economy falling into recession.

Therefore, as it stands, the market, as reflected in interest rate futures, sees no further cuts in store. Moreover, chances are increasing for rates to go up. This is not an unlikely view that the US economy will soon recover but rather that inflation might be getting out of hand. US consumer inflation expectations (one year ahead) as surveyed by the University of Michigan are now at 4.8 per cent, the highest since the Gulf War (October 1991).

The US, of course, is not alone regarding inflation risks. It appears that global inflation risk, this time around, is not cyclical but more a structural issue. As former communist states shift towards capitalism, their economic purchasing power has increased, and in the case of China at an exponential rate. Our analysis shows that overall commodity prices are over 94 per cent correlated with China's nominal economic growth since 1996.

Thailand's April headline inflation at 6.2 per cent (year on year) is the highest since the lifting of diesel subsidies back in 2004/2005. The implied forward curve for Thai bonds now sees short rates rising by 40 basis points over the next 12 months. Such a view will put bonds under pressure. While textbooks would suggest that policy-makers increase interest rates to control inflation, we view that such a recipe is not as simple as the source of inflation, which is a function of external supply/demand imbalance, made more transmittable via globalisation. Raising interest rates will help to control inflation only if the Bank of Thailand (BOT) allows the baht to appreciate, which we doubt the central bank would do, owing to pressure from exporters.

On the contrary, we view that demand side management via monetary policy would be ineffective and would require addressing the supply side issue, for example increasing the country's production capacity. Still, the exogenous variable is that China will continue to grow at a pace envied by most other countries and hence demand for commodities will continue to stoke global inflation. We view that the bond market has yet to price in such expectations and we continue to see risk for local bonds, going forward.