July 2014 Index
August 21, 2014
What Is the Bond Market Telling Us?
Interest rate levels have been confounding many professional investors around the globe. U.S. government benchmark 10-year interest rates began 2014 near 3.00 percent, but they have been sliding back to about 2.40 percent recently. The rally in bond markets and corresponding declines in yields are even more pronounced in Europe, where benchmark interest rates are actually at multi-century lows — even in the economically troubled southern periphery. In Japan, despite the central banks’ and governments’ massive effort to reflate the economy, bond yields haven’t budged.
The developed market economies are having a hard time sustaining growth, in part due to structural issues like demographics and high regulatory burdens. However, lower expected potential economic growth is just one reason why the prices of the debt issued by deficit-happy, heavily indebted governments keep going up. These countries can continue to borrow money without offering investors a real return as long as:
• Depositors don’t trust banks and fear bail-ins (this is especially the case in Europe, where many large depositors prefer government debt over large cash balances)
• Geopolitical instability remains in the headlines
• Banking executives prepare for more frequent stress tests
• Investors remember being caught in illiquid investments in 2008 and 2009
• Asset allocators with strict mandates crowd into high-rated investments
• There is desperation for yield and/or perceived safety
• There remain limited alternatives for acceptable collateral
• Bank lending remains constrained; banks’ coffers are full of trillions of cheap liquidity… that is earmarked to earn a spread on government debt
• Deflationary fears persist
Bond Market Dynamics Have Changed
To many seasoned investors, the bond market is not functioning as it has in the past. The presence of central banks buying large quantities (or forcing banks to buy large quantities) of government bonds is distorting the interest rate picture. The market is less about analyzing economic fundamentals, evaluating credit risk, and gauging inflation expectations… and more about capital flows, banking system fears, and investors’ insatiable demand for yield in a zero percent interest rate environment.
The once famous bond vigilantes — who used to hold government debt issuers to high standards and punish them for big deficits — are now unable to compete with central bank buying, and their impact on the markets has all but disappeared. In fact, many of the same participants that used to be considered bond vigilantes are now part of the desperate herd that is crowding into fixed income instruments in search of yield.
The Developed World Bond Market Conundrum
U.S. bonds seem to want to rally in the face of ending QE (whether economic growth is accelerating or decelerating). The situation in Europe is even more pronounced. Sluggishness in the Eurozone economy and continued distrust of their banking system has driven yields on government debt to historic lows.
We find it interesting that the French government could basically borrow money for 10 years (in Euros) and only pay 1.36 percent. Meanwhile the U.S. Treasury had to pay 2.34 percent to borrow for 10 years (in Dollars). Is a 10-year note issued in fiscally, economically, and politically suspect Paris really worth more than a 10-year note from the U.S. Treasury? An investor buying a 10-year French OAT over a U.S. 10-year Treasury is probably motivated by something other than maximizing the expected real return offered by each bond (as hedging the currency risk between Euro and Dollar costs very little).
One takeaway from the above chart is that U.S. interest rates can go lower. To be clear, we are not bullish on bonds in the U.S. or anywhere else for that matter, but we recognize that on a relative basis, a 2.34 percent interest yield may seem attractive. We expect U.S. rates to rise as the economy continues to recover; we do however recognize that it may take more time.
Inflation or Deflation? Watching the Data, the Bond Market, and the Fed
Another force keeping interest rates under pressure is that recent inflation data are not flashing warning signs in developed markets. In fact, recent data have been coming in quite tame. With many commodity market prices under pressure, deflationary talk is working its way back into the market participants’ conversations again. In Europe, data showing GDP contractions in some countries have caused even more deflation fears.
In the U.S., preliminary data estimate that GDP recovered nicely (up 4 percent) in the second quarter from a very weak Q1. However, in the past few months the U.S. has seen a distinct drop in the prices of certain commodities. This is illustrated clearly in the fact that certain food, clothing, and energy components that we track in our Guild Basic Needs IndexTM (GBNI) declined in June, July, and have continued into August.
Easing inflation pressures keep the central banks more comfortable with their exceptionally easy money policies. Longer term, these easy money policies will sow the seeds of higher prices, but in the meantime investors will have to wait.
Fed Stays Loose, But for How Long?
Just a few months ago the prevailing fear was that the Fed was going to be behind the curve on inflation. Those calls are being muffled by concerns that the global economic recovery is still too delicate for a change in Fed policy. Thus, bond yields have headed lower.
We will get more insight into what Fed Chairman Yellen’s “dashboard” is saying this weekend at the Fed’s annual Jackson Hole Summit, and we are sure markets will have a lot to say.
Investment implications: Watch the data. Watch interest rates. Watch the Fed. Low rates persist for now… artificial or otherwise. This may be unfortunate for savers on fixed incomes… but a low rate environment is usually very supportive of stock markets. Bonds are not paying enough to justify buying them. Stick to stocks of good, growing companies.