Government bond yields in the recent inflationary environment

Source: BZM elaboration based on S&P Capital IQ data
Italian, German, French, Spanish, English and US government 10-year bond yields: weekly moving average: daily records from 02/8/2021 to 01/8/2022.

The graph illustrates the yields on Italian, German, French, Spanish, UK and US government bonds with 10-year maturity, calculated on a daily basis as the weekly moving average for the period between August 2021 and the end of July 2022. We can see a substantial increase in yields, starting from February 2022, when the German Bund moved back into positive values area. During May, the spread with the Italian BTP reached and exceeded 200 basis points. There are several variables that may have driven such increase in government bond yields, among which the macroeconomic and geopolitical environment, with recent inflationary spiral and the Russian-Ukrainian conflict. In any case, this increase seems to be quite generalized, although there are differences in the level of returns between countries, partially related to the credit risk perceived by markets in relation to each country.

During the years following the Great Crisis, to cope with the “liquidity trap”, central banks (ECB and Fed) were forced to redefine the concept of monetary policy. The overcoming of conventional monetary policy in Europe was achieved through the introduction of new instruments: 0IRP & NIRP (zero and negative interest rate policies), quantitative easing and forward guidance. In a nutshell, in recent years the ECB kept rates in negative territory or close to the “zero lower bound”, while continuing to inject liquidity through the securities purchase program and controlling inflation expectations through forward guidance.

In recent years, the Eurozone inflation has been quite contained (generally below the 2% target), despite the level of rates and the massive bond purchase program. However, in February 2022 the ECB confirmed its decision of December 2021 to slow down the PEPP (Pandemic Emergency Purchase Programme), and on February, 24, 2022 Russia invaded Ukraine. Such situation has provided all the conditions for moderate inflation expectations in recent years to change.

Therefore, the recent increase in government bond yields might be partly related to a radical shift in inflation expectations (as showed by inflation linked swaps) confirmed by the 12-month growth of consumer price index in the OECD area, which recorded a value of 8.6% in June 2022(Source: Eurostat all-items HICP). Hence the consequent decision by the ECB in July 21, 2022 to raise the three key rates after 11 years.

With refer to business valuation in high-inflation economies, some precautions may be needed. In light of the particularly low government bond yields, many analysts have suggested the use of a “normalized” risk free rate in estimating WACC, measured either as the long-term average rate of government bond yields, or as the sum of its components (expected real rate of economic development and “normal” inflation rate). Recent changes in the general economic environment and in monetary policies may suggest that the former approach of risk-free rate estimate (historical averages) should be put aside, while it would be more accurate to rely on recent government bond yields, which incorporate medium-to long-term inflation expectations. Consistently, future cash flows should incorporate inflation effects, with appropriate precautions. The estimate of the value at the end of the explicit cash flow forecast period (residual, terminal, or continuity value) should also take into account a nominal perpetual growth rate, which may correspond to the inflation rate or to a higher or lower value, depending on the firm’s cash flow perpetuity real growth rate forecast (zero in the first case, positive or negative in other cases). In order to avoid errors in estimating change in invested capital, which includes nominal and real growth, it may be recommended to refer to real values, both for the growth rate itself and the cost of capital (WACC).