Is inflation coming or not? This question has taken centre stage over the last couple of months, and it has had a significant impact on yields, credit spreads and stock market valuations: one week inflation is thought to be returning, so credit spreads widen and equity investors switch to value stocks; the following week, inflation is not considered an imminent concern and the reverse happens.
Is inflation currently a problem for central banks?
COVID-19 has once more obliged central banks to enter unchartered waters that are difficult to navigate with monetary policies. Plenty of liquidity and government fiscal packages should help economies but could lead to inflationary pressures, not only in asset prices but also in the real economy.
Figure 1 Inflation in USA and Germany since 2000
Figure 1 illustrates the development in inflation in the US and Germany since 2000, and while inflation has increased over that time, it is currently still well under the average for the period.
Furthermore, one must take into consideration the base effect on the inflation numbers. As inflation in this instance is the year-on-year change in the consumer price index, the dip in the that index in the first half of 2020, caused by the first COVID-19 lockdown, will lower the base and thereby increase the inflation calculation. This effect is, of course, something that the central banks are fully aware of and, until there is sustained inflationary pressure, it is unlikely that official interest rates will be raised.
Treasuries and investment-grade bonds
Yields on 10-year Treasuries have clearly increased during the last six months, while those of investment-grade bonds have been falling, at least until last month. Credit spreads have clearly narrowed from July 2020 until now, and excess liquidity has driven investors into investment-grade and high-yield bonds, as seen in Figure 2, below.
Figure 2 10-year Treasury and investment-grade bond yields
At its FOMC meeting on 17 March 2021, the Federal Reserve confirmed a monetary policy that will keep federal fund rates between zero and 0.25%, and said it will continue to purchase Treasuries and mortgage-backed securities at a rate of $80 billion and $40 billion per month, respectively.
In the FOMC statement, the following should be noted:
"The Committee seeks to achieve maximum employment and inflation at the rate of 2 percent over the longer run. With inflation running persistently below this longer-run goal, the Committee will aim to achieve inflation moderately above 2 percent for some time so that inflation averages 2 percent over time and longer‑term inflation expectations remain well anchored at 2 percent. The Committee expects to maintain an accommodative stance of monetary policy until these outcomes are achieved."
In other words, the US economy is currently running an employment “gap” of nine million jobs compared with pre-covid employment numbers, and the Federal Reserve will continue to pursue its current policies until that gap is closed.
European yields going forward
The ECB has supplied plenty of liquidity and purchase programs in order to drive yields in Europe down over the last 10 years. Figure 3, below, shows that it has succeeded.
There is no reason to expect that the ECB will change its monetary policy in the foreseeable future, given the economic impact of the pandemic, EU inflation of just above 1% and large public deficits to stimulate the regional economy.
Yields on 10-year German bonds are still negative, so fixed income investors will continue to invest at real interest rates of between -1% and -1.5%. To obtain positive returns, investors will have to go out further on the yield curve and/or accept lower credit ratings.
Figure 3 German 10-year bond yields
Interest rates in alternative lending now and going forward
As Figure 4, below, shows, the weighted interest rate of our portfolio of loans, after four years of investing, has generally followed the movement in investment-grade bonds, albeit at a higher interest-rate level.
As interest rates on alternative lending are not manipulated by the central banks, they are a particularly good indication of where yields are in the real economy, where private individuals and SMEs borrow.
Figure 4 Weighted average interest rate on Quantrom portfolio.
The outlook for alternative lending remains positive. While volumes are still lower than they were before the first COVID-19 wave, the indications we have received from different loan originators suggest that they expect volumes to increase by 20% - 100% this year depending on the segment in question. Funding is therefore presumably still in great demand throughout the economy.
For investors in alternative lending, one interesting additional development is that loan originators have begun issuing property loans in Germany and other Western EU countries, with interest rates approximately the same as those in Eastern EU countries.
This development is, of course, positive, and we expect it to allow us to diversify our loan portfolio even further.
Even allowing for additional risks, interest rates on alternative lending instruments are currently very attractive and one of the few fixed income investments not manipulated by the central banks. Alternative investment is also one of the few areas that will actually give the investor positive real interest-rate returns in the current environment.