There is no doubt that the biggest bubble I have seen in my investing career to date is what has occurred in long-term government bonds over the last few years. It has peaked on post Brexit “euphoria” and I am strongly of the belief that yields are going to rise and capital losses stack up for government bond holders from this point.
What happens in markets is if something goes on for long enough, investors believe it’s permanent. They start to believe the narrative even though they truly don’t want to be part of it. But in this world of short institutional performance measure periods, passive flows and ETFs, these cycles of crazy pricing can go on for much longer than anyone expects.
I would remind you how “peak oil” theories ended … remember that? Peak oil ended in an oil crash and I feel something very similar is brewing in the government long bond markets over the next few years.
When something goes on for long enough, we all underestimate how much passive and active money it sucks in. We all underestimate the leverage in the asset class and anything that looks like the asset class. We therefore also underestimate how much money comes out of the theme when it reverses.
An ominous calm – an increase in volatility?
The recent two-month period of financial calm has remained in stark contrast to the extreme volatility at the start of the year. The calm was shattered on Friday with the Dow falling nearly 400 points and a spike in global bond yields. Negative yields have driven a global search for yield. Asset class correlation has never been higher. In the words of the rapper Eminem: “ Snap back to reality. Oh, there goes gravity.”
The catalyst appeared to be a warning by fund manager Jeff Gundlach of a major correction for bond yields. Then, a succession of dovish Fed governors turned positively hawkish about the need to begin raising rates. As a result, the US 10-year bond yield rose 14 basis points over two days to close at 1.671% for the week. This marks the highest level since the Brexit vote, and a 30bp rise from the all-time low.
At first glance, nothing suggested a large fall in US equities. Gundlach’s comments echoed similar warnings, the weekly rise in bond yields was relatively benign and the Fed is expected to raise rates this year. Of more concern were the recent actions and comments from the European Central Bank (ECB) and the Bank of Japan (BOJ), which suggest the possibility of a change in the focus of central bank policy.
Bond market fears – Taper Tantrum Mark 2?
It appears the reality of an unsustainable fall in global bond yields has returned to haunt bond investors once gain. In March 2013, a threat by Ben Bernanke to end QE policy led to the Taper Tantrum which resulted in a 140bp rise in US bond 10-year yields. Similarly, in April last year, a 90bp rise in the German 10-year bond sparked a sharp sell off in sovereign bonds and a huge increase cross asset class volatility.
Last week, global bonds succumbed to a smaller sell off under the weight of the financial gravity imposed by negative bond yields. The decision by Draghi against a further increase in the ECB’s asset buying program raised fears of a change to QE policy. This followed comments by Karoda ahead of a summit on the effectiveness of Japanese monetary stimulus, which in turn sparked concerns of a new direction in BOJ monetary policy.
Bank of Japan – the genesis of unconventional monetary policy
The BOJ initiated its experiment in unconventional monetary policy back in 1999. After a decade of limited success in stimulating either economic growth or inflation, in October 2014, the BOJ significantly ramped up its monetary stimulus. The “Big Bazooka” included a comprehensive easing, which expanded the range of asset purchases from Yen 60 trillion to Yen 80 trillion annually. The BOJ was essentially buying 90% of government debt issuance.
The subsequent advent of QE programs and negative interest rate policy from other central banks has helped in driving sovereign yields to extreme levels. The dramatic fall has prompted a widespread acceptance that government bonds remain in an epic bubble supported by unconventional central bank policy. It’s hard to disagree.
Central Bank policy – the winds of change?
Against expectations, the BOJ failed to expand its bond-buying programme in April and July this year. This prompted a fear that a limit to QE policy had been reached. At the same time, the BOJ changed policy tack by buying shorter-dated maturities. Speculation focused on the BOJ seeking a steeper yield curve to mitigate the damaging effects of negative long bond yields on the financial sector.
On cue, over the last three months, Japanese 10-year bond yields increased from -0.3% to -0.01% while the 2-year and 30-year yield spread has compressed to a record 30bps. Further confirmation of a possible change in monetary policy occurred last week. Ahead of a September 20-21 summit on the effectiveness of monetary policy, governor Karoda commented on the detrimental effects of negative interest rates on the life insurance and banking industries.
Has the BOJ changed its monetary policy focus, particularly on negative interest rates? Is the ECB’s decision another sign that central banks are stepping away from the radical monetary policy experiment? Are we witnessing a seminal change in central bank policy? If so, will the bubble burst in an ugly correction or are bonds in the early stages of a long-awaited and slowly-deflating correction?
The Great Bond Crash OF 1994 – Back to the Future?
In this regard, the Great Bond Crash is instructive. In February 1994, the Fed unexpectedly raised interest rates by 25bps. Over the next three months, the FFR was raised by a total of 100bps. Over the next five months, the 10-year bond yield rose 200bps to 7.7%. The volatility was huge, and the losses even bigger, with estimates varying from $US700 billion to a $US1 trillion. A massive figure in 1994.
Japan has led the financial world with unconventional monetary policy. Faced with similar economic conditions, including deflation and an ageing demographic, global central bank policy has followed in lockstep. With nearly $US10 trillion of sovereign debt trading with negative yields, any percentage moves upwards will be significantly larger than 1994. As such, the risks of a disorderly correction are magnified.
In addition, the dramatic search for yield in an ultra-low return environment, has spawned the rise of exotic bond instruments, ETFs and a blow-out in corporate bond spreads. A more important risk is the massive and opaque leverage which is the inevitable outcome consistent with the excesses of a 35-year bull market. The subprime meltdown is the obvious example. The risks of another 1994-style bond crash are more real than imagined.
The lesson from 1994 – Policy communication
While inflation was relatively modest, in 1994 Greenspan was more worried by the prospect of rising asset prices after a 33-month economic expansion. And consistent with a dual mandate of price stability and employment, the Fed raised rates aggressively. The unexpected nature of the change in policy exacerbated the bond market’s reaction. It also marked a change in the Fed’s mandate to include asset prices.
Bernanke repeatedly stated, particularly after the Taper Tantrum, that the Fed would never make the same 1994 mistake again. Yellen is cut from the same cloth. As such, all Fed policy moves are well-communicated though a variety of mechanisms. Since 1994, the Fed has never tightened unless the market probability of a rate rise was at 70% or higher. That rules out September at 16%, but makes December increasingly likely at 61%.
Secular stagnation – a dovish Fed
The Fed is faced with an interesting balancing act. The data currently remains ambiguous. The dramatic fall in the latest ISM figure suggests that the US economy is headed into a recession. In contrast, non-farm payrolls data indicates the economy is close to full-employment. At this point, the risk of an increase in both wages and inflation increases significantly. The Fed is desperate to keep ahead of this inflection point.
At the same time, while central bank policy has contributed to ultra-low yields, long-term structural forces, or secular stagnation, have also acted to lower bond yields to historic lows. The effects of an ageing demographic, deflation and high private/public indebtedness will almost certainly combine to contain both inflation and economic growth. The current low level of real interest rates is the prime example. The Fed remains very dovish.
Despite the current fears, maybe a change in central bank policy will prove to be a positive for market complacency? In 1994, it appeared that Greenspan committed a grave policy error. On reflection, history shows the opposite occurred. Following a savage correction, and with inflation remaining low, bond yields retraced all the previous rises and equities finished unchanged for the year. Subsequently, the bull market continued for both asset classes.
Summary
Let me make myself very clear: anyone who buys a 10yr bond with a negative yield is insane. It is utter madness and it will end like all other insane investment decisions: very, very badly.
Government bonds between 10 & 30 years in duration are “return free capital risk”. When you add on inflation, they are “real return free capital risk” right at the point where central bank support, which is key to everything, is being tempered.
Ask yourself one key question: who is the next marginal buyer of long bonds if it isn’t going to be central banks?
The answer is yields would have to back up dramatically in a 10 to 30 year duration bucket for any sane investor to be tempted. I wouldn’t touch any government bond anywhere in the world for my fund until yields were at least double what we see today. That’s how mispriced and dangerous this bond bubble is, driven by central bank largess and the power of passive investment strategies right at the wrong time of the investment cycle.
I urge you to maintain short-term caution as bond yields rise globally and locally. As they rise, volatility will pick up sharply in all asset classes. And in volatility, there is opportunity.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
