Bonds are at the epicentre of what is a highly fragile environment.
“Brexit brought forward the size, scale, scope and speed of more monetary policy. No wonder markets are up!”
- Former Federal Reserve (Fed) Governor, Kevin Warsh, July 2016
It is often stated that markets hate uncertainty. Like many things this cycle, this notion has been flipped on its head. Having occurred in the context of six consecutive quarters of negative earnings growth, the re-rating of equities that has taken place in the last 18 months has principally been due to falling bond yields.
673 cuts since 2008
Last month, JP Morgan reported that since the collapse of Lehman Brothers in September 2008, one of the world’s top 50 central banks has reduced interest rates on average once every three trading days - a total of 673 cuts. The latest to do so has been the Bank of England who, for the first time since March 2009, cut its bank rate in the wake of June’s Brexit referendum to the lowest level (0.25%) in the institution’s 322-year history.
Since the referendum, the yield on the UK’s 10-year government bond has more than halved from an already record low 1.37% to below 0.60% at the time of writing (22 August).
It’s important to understand what this now implies for future returns.
At a yield this low, a buyer at the current price stands to earn a cumulative total return of a little under 6% (nominal) on those bonds between today and their maturity date a decade from now.
The principle of a bond dictates that nothing can enhance that prospective return. Even driving interest rates to negative levels in the interim won’t change the arithmetic; it would just front-load the returns leaving only losses available to investors for the remaining portion of the decade.
Suffice to say the future returns from this asset class have never been more dismal or their valuations more extreme. Far from being safe, we believe government bonds sit at the epicentre of what remains a highly fragile environment.
How low can they go
Since it was established in July 1694, the Bank of England’s average interest rate has been 6% (it peaked in November 1979 at 17%). Although we may never see a bank rate that high again in our lifetimes, you’re unlikely to see a rate much lower than 0.25% either. Buyers beware.
We don’t wish to spend any time trying to rationalise a 0.6% yield on a 10-yr government bond, as we think it’s irrational and agree with former Governor of the Bank of England Mervyn King that “in the long run it’s completely unsustainable”. But putting that, and the overt repression of yields by global central banks to one side, it appears that ‘the market’ anticipates, and is ultimately positioned for, a sustained period of low economic growth and low inflation the world over.
In fact, at a time when $13 trillion of bonds are negative yielding, that’s probably a bit of an understatement. Nonetheless, the last thing the market seems prepared for is a period of higher growth and/or inflation. And yet, on paper at least, it’s looking more plausible today than it has for a number of years.
Consider the following:
- Monetary policy everywhere is exceptionally loose
- Courtesy of quantitative easing, there is a scarcity of bonds available to investors implying that increased issuance would likely be easily funded.
- The fact that government bond yields have fallen to such low levels means that any public works project capable of generating returns in excess of those yields would not represent a future burden for taxpayers.
- We have a US election campaign underway where both candidates are campaigning on increased fiscal spending. As mentioned above, the Japanese are already in fiscal expansion mode and the UK is forecast to get there too.
- Labour markets in many developed economies are tight, evidenced by low unemployment rates and accelerating wage growth.
- Oil and other commodity prices are significantly off their lows and the dollar is off its highs. Core inflation in the US is already north of 2% and trending higher elsewhere.
The big mess
Now let’s assume for a moment that governments undertake bold fiscal stimulus to counteract what they judge to be secular stagnation (i.e. a prolonged period of lower economic growth). Growth and inflation rebound. That alone ought to pose serious questions to bond investors. But let’s take it a step further. Let’s assume that in this higher nominal GDP environment, the private sector rediscovers its willingness to borrow, spend and invest as central banks hope. Sounds good, right? Well, that’s where it gets potentially very messy.
To borrow from Richard Koo, the chief economist at the Nomura Research Institute:
“Eventually the private sector will complete its balance sheet repairs and resume borrowing. When that happens, inflation can quickly spiral out of control unless the central bank drains the liquidity it pumped into the market under quantitative easing.
For example, excess reserves created by the Fed, at $2.5 trillion, currently amount to some 15 times the level of statutory reserves. That implies that if businesses and households were to resume borrowing in earnest, the US money supply could balloon to 15 times its current size, sending inflation as high as 1,500%.
The corresponding ratios are 28 times for Japan, five times for the eurozone, and 11 times for the UK. Once private-sector demand for loans recovers, confidence in the dollar will plummet unless the Fed reduces excess reserves to one-fifteenth of their current level.
But that sort of extreme reduction in reserves will require the central bank to sell the bonds it holds, which would be a nightmare for both the economy and the bond market.”
Forget 1,500% inflation – that’s merely there to force the point. Forecast inflation sustained at around 2% ought to set the cat among the pigeons.
The market's bets
So, returning to our yield of 0.6%; one of the bets the market is currently placing is that governments won’t run deficits of sufficient scale to compensate for the reticence of the private sector to spend. The market is also betting that the private sector itself will remain moribund for pretty much as far as the eye can see.
The question is whether a total return capped at only 6% nominal is sufficient compensation to take that bet for the next 10 years, given that the potential downside is multiples of that number, especially in real terms. For some, evidently it is. For us, it’s not.
In an environment of recovered animal spirits, central banks would have to set about mopping up much of the excess liquidity the market currently cheers.
But tighten policy and they’ll topple the economy and bond market. Stay loose and they’ll stoke inflation and decimate their credibility. Either way, the balance of this cycle has the potential to be a big mess indeed.
“Until the consequences arrive, idiocy can masquerade as genius, and vice versa. Those two have a remarkable way of reversing over the completion of a market cycle.”
- John Hussman, August 2016