Get Your Coat

The short-lived divergence of global monetary policy in 2017-2018 gave way to the super gravitational pull of negative interest rates in 2019. The unexpected size of the decline in government bond yields has been the engine behind above average returns across a range of financial markets; falling risk-free rates boosted credit returns, low corporate borrowing costs boosted equity returns. It has been a party that very few people were appropriately dressed for. Looking forward, however, bond yields might just plateau at very low levels. That would signal the party is over. Yes, there might be a few good tunes to dance to but unless someone changes the DJ and upgrades the champagne, it might be time to go home.

Celebrate…eh?

Has it felt like a bumper year for you? If you were fully invested in traditional markets it should do. Bond market returns so far this year stack up as some of the best over the last twenty years. This is especially the case in government bonds where returns are in the top 1/3 of the range of the last two decades. This is also true of investment grade credit, especially in the US and UK. Dollar and sterling returns have been very strong while Euro bond market returns have clearly been constrained by the low level of yields to begin with. This notwithstanding, returns from bunds are at the 65th percentile of the last twenty years, with European investment grade credit at the 50th percentile. In terms of riskier asset classes, US high yield is in the middle of its performance range but has still generated 6.6% total return (according to the ICE Bank of America/Merrill Lynch US High Yield Bond index). Emerging market US dollar denominated debt has also had a good year with returns well in the top half of the range. On the equity side, performance is more mixed. The S&P500 has delivered a total return to the end of August of 16.8% putting it at the 70th percentile of yearly returns since 1999. Perhaps not surprisingly, the relative performance of the UK and Hong Kong stock indices to their historical range is not so great but the FTSE100 is still up 7.1% in total return. Of the small sample of markets I looked at, the Hang Seng and the Japanese Topix have had the widest range of total returns over the last twenty years and this year returns in both are at the 50th percentile, which puts them close to zero. Japanese government bonds have outperformed the stock market by close to 3 %.

Your statement says “Good Year”

I am sure for many people it has not actually felt like it should have been a bumper year. I doubt many expected much return from bond funds when the “commentariat” had been consistently describing the bond market as a bubble. Once it became clear that the Federal Reserve (Fed) was reacting to early signs of economic slowdown last December, the expectation amongst many investors would surely have been that a slowing economy would undermine equity and credit returns. Instead, we have had a very good year in US financial markets with total returns to the end of last month (from representative indices) being 7.2% in Treasury bonds, 10.7% in investment grade credit, 6.6% in high yield bonds, and 16.8% in equities. In the UK, returns have been staggering given the political backdrop. Government bonds have returned 8.4% in sterling, corporate credit 11.2% and equities 7.1%. These returns are well above cash and required no fancy investment strategies, leverage, or complex derivative overlays. Even in Europe things have been very good in the context of concerns about slowing global trade and the inability of the European Central Bank to reverse the trend of ever lower bond yields. German bunds have returned 6.5%, corporate credit more or less the same in both the investment grade and high yield sectors and, if you were in the right equity market (France rather than Germany) returns have been well into double digits. We can argue about whether bonds (rates) or equities and credit are properly reflecting the economic outlook and we can describe the rally in governments as being a flight to quality amid increased geo-political and policy uncertainty, but what is it that properly explains that everything has gone up?  

The vortex

The influences on market moves are always complex and rarely evident ahead of time. However, I believe that the positive performance of both safe haven and risky assets this year reflects two things – the first being the belief amongst many central banks that the benefits of persistently low interest rates in terms of combating deflation will outweigh the costs, and the second being the indefatigable need amongst savers (in the broadest sense) to see a positive return on investment. The apparent break-down of the Phillips Curve, the persistent under-performance of inflation and the belief amongst many economists that a number of structural reasons have driven down the neutral real rate of interest are the drivers of the low/negative interest rates policy. The US Fed tried to escape this for a brief period, but it didn’t last long really. As such, the bias towards easier monetary policies has necessarily driven government bond yields down and down. The persistence of negative rates in much of Europe and Japan has been responsible for a downward vortex of bond yields in the risk-free parts of the market. Even when the Fed was tightening, as soon as US Treasury yields hit 3% they were subject to massive buying by currency hedged investors from Europe and Asia. Once the Fed changed its stance, the vortex got stronger as markets anticipated even policy rates in the US would be dragged down to the low levels prevailing in the rest of the Old Word. The derivative of this policy stance has been balance sheet driven investors constantly chasing the market to prevent the duration gap between their assets and their liabilities getting any wider. What that has meant has been lower yields and flatter curves and very strong performance from government bonds.

Happy days?

Government bonds, particularly the higher rated, are never the key focus of investors that have different objectives to pension funds and insurance companies. Investors may have some allocation to safe assets in a portfolio, but the real investment objective is to maximise return for an acceptable level of risk. That is why credit and high yield, as well as equities, are so much in focus. Lower risk-free yields have merely served to make higher yielding assets a destination for investors that haven’t quite good their heads around zero cash rates and negative yields. Credit spreads have remained quite attractive all year. They have not widened significantly because as investors have had to balance negative macro news with the fact that lower rates are good for corporate leverage, they have tended to come down on the side of credit being still a relatively low risk but positively yielding asset class. In many cases the yield on equity has exceeded the yield on bonds, with the prospect of some – if diminished – earnings growth. Neither equities nor credit have been screamingly cheap relative to bonds, they have not been expensive either. They have offered investors the prospect of greater return when the thought process has been that government bonds yields “can’t possible go lower”. The result has been happy days for everyone, even if no-one is feeling that happy.

Snap-back

Just this week there are signs that one side of the story might be cracking, even if temporarily. Rates are higher this week.  Benchmark 10-year Treasury yields have risen 10-15bps, German bunds around 15bps, and UK gilts some 25bps. Several reasons around market sentiment appear to be responsible for this, although the fact that price action in bonds has been so strongly positive over the last few weeks always presented the risk of some mean-reversion. First, there has been some suggestion that the US and China might re-start some serious talks on trade next month. Second, the prospect of a “no-deal” Brexit has diminished following key defeats for Prime Minister Boris Johnson in parliament that should send him to ask the EU for a further extension to the Brexit deadline. Third, tensions in Hong Kong have eased a little. Fourth, Chinese officials have been very open about downside economic risks and are taking additional steps to support the economy as a result. Add to that some technical factors in the bond markets – big jump in supply coming and proposed changes to the reference index for UK inflation linked bonds – and there have been plenty of reasons to take profits on duration. It’s hardly been a “taper tantrum” or “Bund shock” yet but it might be enough to break the cycle of duration buying for now.

But a turning point is doubtful

However, I would not get too excited about a few days’ worth of government bond yields rising. We’ve seen it all before. The real underlying issues remain. As long as market expectations are so biased towards expecting central banks alone being the agencies to deliver stronger nominal growth then interest rate expectations will remain low until growth does surprise to the upside. I’ve said plenty of times recently that some fiscal boost to nominal demand is necessary before there is a sustainable recovery in long-term interest rates. The problem for bond investors now is that movements in rates will impact on total returns in credit and high yield funds unless all of the interest rate sensitivity is hedged away. Then it becomes a timing issue. Have we really seen the bottom in yields? What happens if the European Central Bank cuts the deposit rate again next week and re-starts bond buying? Is that a recipe for significantly higher bond yields? My response would be that such a policy action suggests deep concern about the economy and, henceforth, reasons to expect yields to stay low.

Not enough demand for capital

A sustainable increase in real borrowing costs will only come about when there is more demand for capital from both corporate and official borrowers. Bigger budget deficits and more animal spirits in the private sector would do it. It would also need to be global as even a big fiscal boost and monetary tightening in the US in 2018 failed to raise global bond yields significantly. The key lesson from Japan is that once low inflation and inflation expectations become embedded, it is hard to get companies to borrow to invest when they think their future revenues will be undermined by falling prices, and it is difficult to get consumers to spend today if they think prices are going to be lower in the future. Instead they save, exacerbating the deflation and keeping long term rates very low. If it goes on too long, even reckless fiscal policy can’t break the deflationary grip. This is the risk for Europe.

Exploding the black hole

The unexpected extent to which risk-free rates have fallen this year have been the fuel that has driven financial returns as yields have been dragged down across the credit and maturity curves, and equities have benefitted from the earnings versus cost of borrowing relationship. This is unlikely to be repeated, irrespective of what the real economy does. Yes, the US does have a lot of scope for rates to fall and I do think returns from US fixed income will be superior to those in Europe for the next several months. But the more yields collapse into the vortex, the less potential return there will be in fixed income. The biggest thing in the financial markets over the next year will be the thing that, if possible, explodes the black hole of negative rates.

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