In past letters, we have often written about the ineffectiveness of zero/negative interest rate policies, indeed their adverse consequences – reduced bank lending, unproductive corporate financial engineering, inflated asset prices and mounting social inequalities. But we must say that we find the lack of economic boost from lower unemployment and oil prices somewhat of a mystery. A number of “structural” explanations have been put forward for poor economic performance across the developed world, notably consumer deleveraging, falling productivity and increasing regulatory barriers.
Whatever the true reason for the disappointing growth, it would appear that governments are now finally understanding that relying on central banks to just do more of the same will not work. Slowly but steadily, fiscal policies are shifting, witness the EU decision (backed even by the German Finance Minister) not to punish Spain and Portugal for their above limit budget deficits. The era of austerity could well be ending, with a positive economic impact to be expected in the short term but very dangerous longer term consequences – especially considering the inexorable growth in social expenditures implied by unfavourable demographics.
If greater public spending is indeed the direction that is taken during the next quarters, then government bond issuance will increase – in order to finance the larger budget deficits. Whether central banks maintain, indeed step up, their pace of government bond purchases will then be the key question. Should their buying actually subside, the law of supply and demand will drive bond prices down – i.e. bond yields up.
A number of other developments could also push interest rates up. Higher inflation is an obvious suspect, however difficult it is right now to imagine such a development, as would be a default scenario for say Greece or Italian banks. And then of course there are always the “unknown unknowns”...
All this to say that, while not arguing that a rise in yields is imminent, we are becoming increasingly wary about the bond market. Never before have sovereign interest rates been so low, meaning that we are witnessing the biggest bond bubble in history. Who even remembers the early 1980s, which saw the 30-year US Treasury bond yield over 15%?
In today’s world of “secular stagnation”, many investors actually still consider negative yielding bonds as “safe” investments. A report published by Fitch at the end of June put the global total of sovereign debt trading at negative yields at a staggering USD 11.7 trillion, up USD 1.3 trillion (or 12.5%) for the month. Fitch mentions Brexit-related concerns as a driver of more long-dated bond yields into negative territory, with particularly big shifts having occurred in German, French and Japanese yield curves. As such, JGBs (Japanese government bonds) account for some two-thirds of the current total, with Germany and France each having over USD 1 trillion of negative-yielding debt.
Disbelief in a Federal Reserve (Fed) rate hike this year, indeed even next year, is but another sign of bond market complacency. According to BCA Research, investors are currently assigning only a 36% chance of the Fed acting in 2016 – and a 73% chance in 2017. While recognizing that the Fed is being hampered in its tightening action by various domestic (disappointing growth, forthcoming presidential election) and international (US dollar strength, weak global/Chinese economy, financial market jitters) factors, we would not be surprised to see the US central bank make another move before year-end.
Our main message this month is thus that the time has come to protect gains on bond holdings. In normal circumstances, selling the positions outright would be the obvious course of action. But in today’s investment world, this essentially means holding the proceeds in negative yielding cash or taking yet more risk in expensive equities.
As such, our preferred strategy is to reduce the duration of the bond portfolio by shorting futures on (say 5-year) US Treasuries – in situations where the cost of the short position is lesser than the carry still provided by the bonds. Given the minimum trading size constraints in the futures market, note that it is also possible to purchase Exchange Traded Funds (ETFs) that short the Treasury market.
Should this duration mitigating option not be feasible or desired, then we would recommend that the fixed income positions posting large capital gains be sold and replaced by inflation-linked bonds. With financial markets completely overlooking any prospect of inflation rising in the foreseeable future, the opportunity cost of such a swap is currently very low.
Again, we do not purport to time the bursting of the bond bubble. A rise in yields might not be imminent. But when it does occur, and for whatever reason (greater fiscal spending, inflation pick-up, sovereign or corporate defaults…), we would hate to see unprotected capital gains be wiped out in a flash.