Blain's Morning Porridge, submitted by Bill Blain of Shard Capital
“We’re only making plans for Nigel. He has this future in a British Steel..”
It’s always about the bond markets…!
Markets look to have stabilised after last week’s flight from stocks to bonds. The market panicked on the lack of resolution on trade wars, the perceived rise in the risks of recession over the next 18 months, and the gut-feel stocks are over-valued and due a reset. However, this week the fear is receding. The market has shrugged off the concerns. Mr Market figures some kind of compromise will be reached on trade, the inverted yield curve wasn’t a real signal of recession, and how can we fear slower growth when the US economy is so fundamentally strong? (Although Trump is screaming at Powell for a 100 bp ease!) There are very real problems – like Germany looking likely to slip into recession – but, generally it feels like the market has persuaded itself it’s all FINE.. Its recovered. Somewhat.
As any man will tell you.. FINE is possibly the most dangerous word in the world… When a wife or the market says its FINE – you know you are in the deep solids.
One of the clues as to what might happen next is bond markets. Last week was a spectacular flight to safety rally in Government bond prices (with commensurate fall in yields to record lows). Debt funds have posted spectacular gains – bonds proving the top performing assets in terms of total returns. The whole German yield curve is now negative – and it will launch a long 30-year bond with a 0% coupon this week. The USA is mulling a 100-year century bond. I’m sure my chums across the road in the UK Debt Management Office are looking at the Century bond concept again. And so they should be. I could sell it in a heartbeat..
But there are a few issues. To continue delivering stellar returns, the bond market needs to keep rising and yields to go even lower. Many investors now suspect low rates might have become a trap. We’ve been seduced by just how low yields have gone. Can they go lower still? This raises a whole series of questions:
Why should rates go lower? Central Bank efforts to stimulate real economic growth through lower rates have proved singularly ineffective despite bond purchase programmes, QE and other experimental policies. Engineered lower rates have had the unintended consequence of driving up the stock markets through yield tourism and corporate buybacks, rather than fuelling real economic growth.
For real growth we need real returns through normalised interest rates. A large part of the market has been happy to lap up the benefits of lower for longer rates in terms of inflated financial assets prices, but increasingly they are exiting asset markets where prices have been distorted by these policies – and that includes stocks and bonds – and are looking for alternatives.
It increasingly looks like economies have a “stall speed”: when rates go too low the economy stalls. They need real interest rates to drive investment in real assets. If an economy stalls, then you get Japan. And guess what? The number of research and analyst notes suggesting the Japanification of Europe or the US has dramatically risen in recent months.
There are now a number of bond funds now quietly exiting bonds figuring the gains we’ve seen on fears of global slowdown are vastly overplayed, and taking the view it’s time to move some bond cash off the table. Check out this story in FT – “Pimco has pared positions in government debt as it fears a violent sell-off, putting an end to one of the biggest fixed income rallies in history.”
Anyone trying to exit corporate and high-yield debt position is finding chronic illiquidity makes any exit expensive. Even government bond markets have proved highly illiquid through the summer –Treasury market bid/offers have widened. It’s too easy to simply blame thin summer markets for illiquidity – bond market liquidity has been tumbling since the 2008 crash. Dealer inventory is close to zero. Everyone is just a bond broker. (As I’ve said before – if a crunch comes then corporate debt markets will be about as liquid as concrete..)
As bond issuers looking to pay the lowest rates it’s no surprise Governments are thinking about how to use ultra-low interest rates to finance growth and infrastructure projects. It makes perfect sense to take advantage of the opportunity. The US is out there talking about a 100-year bond again to cater to investors looking for duration – the bond’s sensitivity to yield changes.
The 100-yr Austria bond has gone through the roof since it was launched 2 years ago. It works because Austria is perceived to be a decent sovereign credit. Bloomberg’s Mark Gilbert pointed out last week that what goes up will go down just as fast when yields rise. Apparently 40% of the Austria bond is held by UK accounts! I suspect they will try to buy even more of a US Century Bond or UK 100-yr Gilt – driving either bond to a spectacular highs.
Interesting to see what happens next…