Over the long run, total return in bond investing is driven by income. This year it has all been about capital appreciation. Bond prices have moved aggressively and this leaves the market subject to the risk of a correction. If monetary policy expectations are not met or if there is some event that lifts investor optimism, government bond yields could snap back significantly. A tantrum if you like. Yet, a core scenario still has to be that rates markets are right in anticipating further economic weakness that will eventually take its toll on credit and equities. It’s still a bond world, but maybe a bit more Timothy Dalton than Daniel Craig.
Bond yields have bounced a little in the last week but August has seen a tremendous net move lower in yields, particularly on longer-term government debt. The yield on 30-year German government bonds reached -0.27% on August 15th, 30-yr gilt yields got down to 0.95% and US Treasury 30-year yields fell below 2% for the first time ever. Austria issued a 100-year bond in 2017. Last week the yield on that bond fell to 0.60%. This week the German government issued new 30-year debt with a 0% coupon. Yes, that’s right. If you bought that bond and you hold it for 30-years, your return will be zero. Yield curves have flattened aggressively over the last month and there is a strong expectation that global monetary easing has a lot further to go.
The question of a bond bubble has come up again. If it is a bubble, it is a bubble of fear rather than greed. Buying bonds with a guaranteed negative return is not a bubble in the same way that buying tech stocks was in 1999 or CDOs in 2006. It is not an expectation that returns on the investment will massively outweigh the risk. What drives high quality government bonds to trade with increasingly negative yields is the expectation of exactly the opposite – that risky asset returns will be massively dwarfed by the potential risks. The fear is that we are at the end of a long economic expansion, that there is a significant risk of a recession in the US, that Europe is in a long-term stagnation comparable to that of Japan for the last twenty years and that populist politicians have the capacity to do unexpected things that will upset economic relationships and financial markets. At least with a zero coupon German bond you will get your money back. Arguably, and I have some sympathy with this view, risky assets like credit, high yield and equities have not fully reflected the downside risks.
A rate move too far?
Having said that, there is the risk that interest rate markets have overshot. Bund yields are 25 basis points (bps) lower than the ECB’s deposit rate. Treasury 10-year yields are 75bps below the Fed Funds rate. In the UK, the gap between 10-year gilts and the Bank of England’s base rate is nearly 25bps. If central banks do no satisfy market expectations for lower policy rates, longer-term yields could back up aggressively and all the investors that are late to the long duration party will take a price hit as a result. This has to be a risk in the short term given the dynamics of the bond market in recent weeks. A number of Federal Reserve officials have suggested that there is no strong argument for further cuts in interest rates in the US. At the July 31st meeting when the decision was taken to cut rates by 25bps, the decision was not unanimous. Despite President Trump’s insistence that the Fed is doing a bad job, Fed officials are determined to make decisions on the basis of an economy with a very low unemployment rate and steady growth.
Most of the return across all bond sectors this year has come from price appreciation relative to income. That is unsustainable. Over the medium to long term almost all returns from bonds comes from coupon income – the price impact is neutralised over time by the fact that most bonds are issued at 100 and redeem at 100. So 2019 is rather unusual and the last three months have seen price appreciation outweigh income by a margin that has only been seen on a few occasions in the past, the last being the period in 2008-2009. Price action is more or less mean reverting in bonds which suggests that capital appreciation is unlikely to persist at the pace of the last few weeks. It also suggests that there will be negative price action at some point. At the same time, income returns have been slowly eroding because yields are falling and the average level of coupons has been declining – a scenario that has been going on for years. Put the two together and it is not difficult to see how total returns are unlikely to match the levels registered in the first half of the year. This week’s back-up in yields is a reflection of the positioning of the market.
But yields to remain low
Notwithstanding all of this, I remain of the view that a sustained increase in yields is very unlikely until something happens to change the macro-economic outlook. The rates markets may be too pessimistic but when we combine a more challenging economic environment (slower global manufacturing and lower global trade) with uncertainties over policy and geo-politics (Brexit, the change of a further escalation in tariffs on Chinese exports, the risks around the Hong Kong situation) and the very positive technical trends in the bond market the conclusion is still rates staying lower for longer. Unless there is a policy induced reason to raise economic growth and inflation forecasts then the most likely sequence of events remains slower growth, lower interest rates and increased risk market volatility with the chance of wider credit spreads and significantly lower equity markets.
Where does it end?
What could lift the gloom? An increasingly unpredictable President Trump could be banned from Twitter. Or he might reach a trade deal with the Chinese, desist from trying to buy parts of the world that don’t belong to the United States and leave the grown-ups at the Federal Reserve to manage monetary policy without threatening 30-years of credibility and the dollar’s reserve currency status. The Europeans might all agree on the need to allow some slippage on the fiscal side to boost aggregate demand. Boris Johnson might strike a deal to allow an orderly exit from the EU for the United Kingdom. The Fed might just be bold and cut rates by 100bps, re-steepening the yield curve and raising expectations that company earnings and wages can rise.
There is of course a deeper malaise that lies behind the low level of bond yields globally. It reflects low economic growth prospects that themselves are a result of low productivity in developed economies. This is a complicated subject and issues like education levels, taxes and regulations and demographics are all part of the mix. Returns on capital have diminished which reduces the incentive to invest and the opportunities to make good real returns on a broad scale. While residential housing and financial industries have increased their share of investment and GDP in some economies over recent decades, there has been underinvestment in social goods, infrastructure and training. If we are to break the trend of lower rates and disappointing growth, not to mention inequality, then governments have to put economic policy front and centre and start to think about how to boost productivity more meaningfully than in the past. Using fiscal policy would give a head start. Borrowing for 30-years at zero interest rate means that the burden on today’s and future generations is much less than it has been in the past.
Risk or safety?
All things are possible but the probability of a significant upgrade to the global economic outlook is not great at this stage. Thus my preference is to put on the hard hat and batten down the hatches this autumn. Credit wobbles like Argentina and General Electric are not to be ignored. If rates back up for nothing other than mean-reversion or other technical reasons, risk assets might respond badly. They did during the taper tantrum in 2013 and the Bund shock of 2015. A period of reduced exposure to rates and credit sensitivity might be in order, awaiting higher credit spreads and more certainty on the rates outlook globally. So, with Austria and Argentina both having 100-year bonds, which one would you invest in today? The Austrian bond trades with a price of close to 200 and a yield of 0.7%, the Argentina bond trades with a price of 48 and a yield of 14.5%. If you believe that default risks will diminish in Argentina after the October Presidential election then the carry on a 14.5%, yielding bond rated at B- is hugely attractive. If, on the other hand, you think the global risk environment gets worse, then a AA+-rated bond with a duration of 57 years might be worth holding a little longer. After all, a 25bps decline in the Austrian yield is worth as much as a 250bp move in the Argie one. Are you bullish risk or bullish safety?
It’s too early to say anything meaningful about the football season but I am happy with United so far. Back to cricket then. The Ashes series is nicely poised. As I write, England have the edge in the third test but are one down in the series. I went to Lords last week and was disappointed to only see a couple of hours of play due to rain. Hopefully this third test match will not be interrupted any further. The most exciting thing about the series is the emergence of Jofra Archer as England’s main bowling attacking weapon. He took six wickets on Thursday bowling at 85-95 miles per hour. He might just be the difference.
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