Bond Market - Phone Home
If the U.S. Federal Reserve were a hedge fund, its phones would be ringing off the hook with prospective investors wanting fresh allocations and Ben Bernanke would be zipping around the French Riviera in a gold-plated helicopter. The Fed’s multibillion-dollar position in Treasuries is nicely in the money with the recent moves to record lows risk-free yields, after all. But it’s policy outcomes, not returns, that the Fed is after. By that measure, the current record low payouts in “Safe Haven” bonds (U.S., Germany, U.K, for example) are troublesome. There is, of course, the worry that they portend a global recession. This concern cannot be waved away with the notion that a worldwide flight to quality totally upends the bond market’s historical function as a weather-vane of economic expansion and contraction. Beyond this concern, however, Nic Colas of ConvergEx sees two further worries. The first is that the Fed has needlessly compromised its independence by pursuing bond purchases that, in hindsight, were unnecessary in the face of the current economic outlook and investment environment. The second is that interest rates have been demoted to a supporting role in kick starting any global economic recovery.
Movies about aliens usually come during the summer blockbuster season of lightweight entertainment, but the history of this science fiction genre is solidly grounded in the world of social commentary. That’s the upshot of an article by Laura Miller in a recent edition of the The New Yorker, and it got me thinking about everything from Darwinism to the state of the global capital markets. She traces the history of fictitious accounts of alien invasions all the way back to 18th French literature; Voltaire wrote of a 6,000 foot alien who comes to Earth simply to examine life here. After Darwin’s publication of On the Origin of Species in 1859, the story lines change to invasions of deadly creatures from outer space, hungry for either natural resources or human blood.
The landmark book of this version of evil aliens, of course, H.G. Wells War of the Worlds, published in 1898. Made even more famous by Orson Welles’ compelling radio adaptation in 1938, it told of an invasion of Earth that was only defeated when the aliens succumbed to bacterial infections to which they had no defense. At the time England was still a colonial power, subjugating millions of indigenous peoples around the world while occasionally suffering from the local diseases against which they had little defense. That made War of the Worlds a thinly veiled criticism of colonialism, of course, but the notion that Darwin’s theory of “Survival of the fittest” might apply across planets was another subtext a reader in turn-of-the-century Britain would also understand.
To stretch the allegory of alien invasion to the capital markets, I would put bonds – specifically government securities of less-risky sovereign nations – into the role of the unwelcome newcomer. The recent drop to record-low interest rates for U.S., German, Swiss, Swedish and other government issuers over the last 10 days is a powerful signal that much has changed in global capital markets. A few supporting points here:
- Consider that current U.S. 10 year Treasury rates are roughly 100 basis points lower than the depths of the last recession. A yield of 1.45% on this security certainly indicates that markets have soldered closed the “Risk on/Risk Off” switch which has governed market action over the last three years. Long dated Treasury yields are also a bet on inflation, however, and such paltry payouts certainly make the U.S. government bond market a significant Doubting Thomas on the topic of domestic economic expansion.
- Similar action in the German bond market – sovereigns there now yield just 1.17% - is a large flapping red flag on the sustainability of the euro in its current form. Buyers of this debt are no only seeking out a safe haven – U.S. Treasuries yield more, after all. They are also handicapping the direction of a currency, the euro, and expecting that future actions will strengthen it. Lastly, yields on German bonds are an indictment of the safety of similar sovereigns in periphery countries.
- While the U.S. and German bond markets get much of the press, we cannot ignore the fact that the last 10 days have seen sharply lower sovereign yields everywhere from Hong Kong to Australia to Sweden and even marginal credits such as France. Just like the old Elvis record – “50 Million Fans Can’t be Wrong” – there is something daunting about any move in capital markets to new highs/new lows. “Return of principle” has won the day.
As with unfriendly aliens unpacking their bags at a landing site, the move to record low rates around the world is a truly menacing development. It says, essentially, that there is real trouble ahead. Those who are bullishly inclined to risk assets might counter with the notion that these recent moves are just the latest round of hand-wringing in what is still a slow growth recovery with reasonable profits need to consider the following points:
- The U.S. economy is weakening, as exemplified by – but not limited to - last Friday’s Jobs Report. The Federal Reserve’s primary weapon – Quantitative Easing/Operation Twist – has proven more shotgun than phaser-set-to-kill when it comes to creating sustainable growth. Granted, the Fed’s +$2 trillion book of bonds must be nicely in-the-money. But central banks aren’t hedge funds, so this is a pyrrhic victory at best. The Fed may not be out of bullets/shells, but a third round of Quantitative Easing will likely be greeted with more yawn than rousing cheer by markets already scared deep into their rabbit hole. And there is the question of whether the Fed even had to pursue such a strategy. If QE has lowered interest rates by 30-50 basis points, as the Fed claims in several papers, then its moves take second fiddle to what the market has accomplished on its own.
- Recent moves to record low yields are a loud vote of “No confidence” when it comes to European policymaker steps to stem the ongoing problems in Greece and Spain. There is a no-polling rule in Greece which will limit visibility this week on the outcome of the next round of voting there on Sunday. The state of Spanish banks, beset by a horrible local economy, seems to weaken by the day. Germany hasn’t yet changed its tune on Eurobonds. I can go on, but you get the idea.
The most optimistic bit of our aliens-bond market analysis is that, in the end, the humans always win. Sometimes we find the mother-ship and destroy it. And, as with War of the Worlds, sometimes victory is the result of time and lucky happenstance. It seems like we are heading down the second narrative. Historically, low interest rates have generally sparked economic recovery. In the current environment, this gas-down-the-carb approach seems to have simply flooded the engine of growth. Other factors are at play, as I have outlined here. The real answer is simply more time.