David Roberts

Central banks exacerbate extraordinary bond markets

David Roberts

ECB and Federal Reserve

We live in an extraordinary world, one that is unique in the 500 or so years of recorded market history. Never before have governments been able to fund deficits below inflation; never before have people, for whatever reason, been prepared to lend for negative returns – not just to sovereign borrowers but now to corporate ones as well.

In recent days, this situation has been exacerbated as comments from US and European central banks have persuaded investors there may actually be further interest rate cuts on the horizon. Indeed, you now have to lend to Germany for over 20 years to see a positive nominal return – deeply negative in real terms of course. Only a few months ago, we earned a little to lend to Mrs Merkel, as the chart below shows.

Yield on 10 year German government bonds

Commentators have shouted about how the equity market is demanding lower yields, with “technicals” such as inverted yield curves and lower inflation expectations supporting this thesis. This is part of the reason many global equity markets have surged to all-time highs but is it correct? Are bond markets signalling lower forever risk-free rates? Well, no.

  1. The myth of a flattening yield curve

    People get excited about the short part of the rates curve and claim that if two-year versus five-year goes negative, a recession is inevitable. For me, this is rubbish: this is the most volatile, most traded, most easily manipulated market around.

    A much better long-term proxy is the relationship between five and 30-year bonds: this tells us what professional, long-term investors think of current and imminent central bank policy.

    Yield spread between US five and 30-year government bonds

    As the above chart shows, this curve has steepened dramatically over the past year. Inflation has been sticky around 2% in the US (despite suggestions to the contrary) and pressure to cut rates coming from the President has spooked long-term investors. Why? It’s very simple – in a free market, if the central bank is “behind the curve” (taking a risk with inflation), then in the long term you want more yield to compensate for this risk.

    Looking at this curve, professional bond investors are growing more scared by the day of the long-term implications of easy money – of course, the Federal Reserve could always restart quantitative easing, target long-term bonds and keep yields lower this way. Who actually needs the bond market to represent value anyway? Life funds, banks, pension funds, next generation investors – no one this generation needs care about.

  2. Inflation expectations are dead

It seems European Central Bank President Mario Draghi and Fed Chair Jerome Powell may finally have gone a step too far – or they may argue this is finally what they want. The extra yield to own US Inflation Linked Bonds had been collapsing since March, not a surprise given the vehement “inflation is dead” rhetoric we have been hearing.

Since the latest round of Central Bank meetings, this extra yield, the inflation premium, has jumped markedly – although it is still a long way below recent averages. This is no guarantee we will see inflation rise (actually it doesn’t need to do so to justify owning inflation protected bonds here), but it is a clear signal that professional bond investors believe enough is enough.

A final comment: G7 central banks are taking a risk. We have full employment, rising real wages and inflation close to long-term averages. Real and nominal rates are already at record lows. Ask yourself this: which basket of countries from the below has had rampant inflation and which have had more modest inflation over the past century:

  • Switzerland, Japan, Norway
  • 1970s UK, 1930s Germany, Zimbabwe, Argentina, Turkey

Jerome, Mario and friends – are you managing monetary policy to support the economy or simply to boost the value of financial assets? These are two very different things.

In terms of how all this has been influencing positioning in our Strategic Bond portfolios, we currently have around a third of the interest rate directional risk of the global bond market.

We tend not to look at the market or indices too much but, for those who buy passive bond funds, it may be worth recognising you are buying a long duration asset, longer than it has ever been at a yield lower than it ever has been. When a market becomes ridiculously expensive, when we cannot justify the risks, we are happy and should be expected to sell it.

Looking around the world, almost all core sovereign bond markets are too expensive and almost none compensate for inflation, let alone nominal growth. The US has, for some time, been the winner of the least ugly contest.

We have done well in a rising market despite not taking much directional risk. Why? We have owned US bonds and had a short position in Germany since we launched the strategy last year. This is a strategic position: US bonds have significantly outperformed over this period and our investors have captured the gains. We don’t expect this to change any time soon.

In terms of curve positioning, many other investors owned long-dated bonds and avoided short dated, playing the so-called flattening trade, but we did the opposite. As yields have collapsed, long bonds (at least in the US) have struggled.

Because professional investors believe yields are too low and are stoking future inflation, they are avoiding buying those longer assets which could end up plunging in value in absolute terms (around 30% or so) if inflation comes back.

Coming finally to inflation, last week you could buy five-year US index-linked bonds at a break-even spread of 1.4%. This means people “expect” inflation to average that level or lower for the next five years – despite the massive stimulus, despite full employment and despite the average of the past 10 years being 1.7%. With this in mind, half of our US interest rate risk is now invested in TIPS (Treasury Inflation Protected Securities) and the good news is that the break-even has risen to 1.5%, meaning our bonds have added value compared with conventional US Treasuries.

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Key Risks


Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. Investment in Funds managed by the Global Fixed Income team involves foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The value of fixed income securities will fall if the issuer is unable to repay its debt or has its credit rating reduced. Generally, the higher the perceived credit risk of the issuer, the higher the rate of interest. Bond markets may be subject to reduced liquidity. The Funds may invest in emerging markets/soft currencies and in financial derivative instruments, both of which may have the effect of increasing volatility.




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Monday, June 24, 2019, 12:34 PM