I’ve talked a lot about the bungee cord in the past few months, that is holding the US longer end from taking off. But the bungee is more than just the ECB and BOJ QE. Implicit in the QE policies (aside from manipulating the FX in those economies’ favor, eh hem) are the inflation and demographic structural forces that cause the QE to be implemented in the first place. So to figure out when the bungee cord will break could amount to getting a better idea of when we could see some signs of inflation or a change in the demographic patterns. Inflation and demographics are something I’ll be thinking more about in the coming years.
I’m going to start with the demographics. In particular, the aging baby boomers having started to retire means there is a larger demand for fixed income assets from retirees, pension funds and life insurance companies to pay for retirement benefits. Calpers is supposed to have a meeting next week to discuss a potentially larger allocation to fixed income. They can not be alone. That is one of the reasons why the longer end has been so bid – not just by US institutions, but by institutions worldwide. It’s not a coincidence that the longer ends of the US, UK and Canada (all “higher-yielding” developed economies) all rallied strongly last week.
An interesting fact about the aging baby boomers is that the oldest of the baby boomers reached age 70.5 this year. 70.5 happens to be the age where many retirement plan (i.e 401(k)s) require mandatory distributions. Could this cause the equity and fixed income selloff? I dunno. Did the Fed tapering cause a fixed income selloff? So the answer in the short term is “no.” But this could take longer to take effect. The effects will be cumulative. We may not feel the effects of the Fed taper for a couple of quarters. Similarly, considering there are almost two decades of baby boomers, it may take a while for the effects of small annual mandatory distributions to add up to something more substantial. This age 70.5 distribution example is just one of the many things we need to start thinking about, when trying to pick a catalyst for fixed income rate normalization. From time to time, I’ll start discussing some other catalysts.
Why am I talking about retirement, when the central banks have an inflation mandate and no “retirement mandate”? We had a huge surge in population after World War II (aka the Baby Boomers). It would be lazy to ignore the effects of demography when looking at trends in the markets. For example, I thought this chart was very interesting. It shows that when the number of workers per dependent (young and old) starts falling, we have had a financial crisis. There were probably other factors involved, but it does make sense that when you have fewer productive members of society as a percentage, you would expect an economic downturn. A larger base of older retirees could affect the productive capacity of an economy. You could argue older workers tend to be more experienced, more productive and earn more. It can’t be a coincidence that low productivity and wages have been the hallmarks of this “recovery.”
A larger older base may also affect spending. The reason I think inflation could stay low for a while is the chart on the right that shows the relationship of inflation and the retirement population for the top 25 economies in the world. You can see there is a clear pattern of lower inflation, as an economy has more elderly. This is certainly not a “smoking gun” in way, and there could be other explanations. But this does make some sense intuitively. Retired people probably tend to spend less money than when they are working – downsizing, less commuting, and maybe even budgeting for a fixed income. I don’t even want to get into what a resource-pit raising kids can be. So a shift to a noticeably quieter lifestyle is going to put downward pressure on spending.
The US isn’t getting any younger. In 2015, 16% of the population was over age 65, but by 2050, this is projected to increase to 22%. The rest of the developed world is probably on a similar trajectory. As a result, if the above chart holds water, trying to be short fixed income could be like trying to swim upstream.
However, I do think we could eventually get a massive fixed income selloff as the baby boomers start liquidating their assets. As a group, baby boomers are still probably accumulating assets, as a bulk of them have not retired yet and people are working longer. I also think the government debt could explode trying to pay promised retirement benefits (Social Security, medicare, pensions, etc). The question becomes… when does the bungee cord and dam break?