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Rising capital market returns stoke fears of inflation

Does the current rise in capital market returns mean a return to inflation? This is a hot topic on the markets at present, and investors are showing concern. Read why this trend does not yet mean a return to inflation.

Capital market returns are growing at record speeds in the US

The latest rise in capital market returns is most apparent in the US, where yields on ten-year Treasury bills rose in just a few days from about 2.8% to about 3.2%.However, ten-year Bunds also rose to an impressive 0.5%. Ten-year Swiss government bonds reached nearly 0.1%. The following three factors were influential:

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Factors influencing interest rate movements
 

Source: Credit Suisse

Interest rates and inflation: Déjà-vu on the markets?

While inflation in Switzerland is currently 1% and even about 2% in the euro zone and the US, inflation-protected income (TIPS) in the US is at 1.07%, the highest figure since 2011. Back then, ten-year capital market returns in the US were at 3.58% and inflation was 2.5%. It is entirely possible that ten-year T-bills will reach this level again. Certainly, an increase of this kind in the US would influence the capital market returns in Switzerland and the euro zone, along with exchange rates.

That said, fears about a structural shift in inflation seem exaggerated. Inflation is mainly caused by disruptions in free competition. The latest study by Credit Suisse, "The SME sector in Switzerland is in good shape", explains how international competition even affects domestically focused SMEs in Switzerland and closely limits room for price adjustments. Therefore, the current inflation trends can be seen as a cyclical development and not a structural one. 

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Source: Haver Analytics, NBER, Credit Suisse
Past performance and financial market scenarios are not reliable indicators of future results. 

US sanctions boost inflation

The inflationary effect of sanctions, such as the US government has been placing on imports from China to the tune of USD 250 billion, is also overestimated. Compared with US GDP of USD 20,000 billion, its influence is lower than the effect of rising oil prices, for instance. Of course, this may change if a growing number of US companies move their production sites back to the US, but we are still a long way from that. In terms of inflation, US sanctions against Iran are currently of greater relevance than the trade conflict with China. 

High government debt does not necessarily mean higher capital market returns

So what is the impact of rising national deficits? The assumption that debt can lead to higher capital market returns or even an increase in inflation may seem intuitive at first. However, government debt has been on the rise in Europe, the US, and Japan since the 1980s, but has not yet led to a structural interest increase or inflation in any country. On the contrary, over this period interest and inflation have been on the decline in Europe, the US, and Japan.

So what happens if foreign creditors sell off their US Treasury bills? This concern is not new, but is not based on facts. In the first half of this year, foreign investors sold off US Treasury bills to the tune of USD 267 billion. The total amount of US Treasuries held by foreign nationals, more than USD 6,200 billion, has been growing almost continuously since the 1990s. They are not likely to be a weapon in the current trade conflict.

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Foreign creditors hold large amounts of US T-bills 
 

Capital market returns rising along with growing real interest rates

In short, the latest rise in capital market returns seems to be mainly driven by a boost in real interest rates, and less so by structural inflation changes. The relatively low returns in Europe and Japan are a sort of regulating factor that, if US returns overheated, would automatically help shift the trend downward. The mere fact that real interest rates, especially in Europe and Japan, are currently at their lowest levels in 70 years indicates that real capital market returns can stabilize at a high level.