Trouble is afoot, again, for the bond markets. Could bonds today be more unsafe than stocks? For the long maturities in the global bond market, it appears so, at least in the near term.
Despite the jawboning known as “forward guidance”, central bank support for bonds is naturally beginning to ebb as global economies regain their footing, asset prices make all-time highs, and the escalating rhetoric of currency and trade wars paints a bulls-eye on artificially low global yield levels. For the last few years, the low (negative) level of yields in Germany and Japan has been the “fountain of youth” for all markets, primarily for global bond markets. But now, the wall of “free money” that seemed to stretch as far as the eye could see, is beginning to look shorter. The fountain of youth is beginning to turn to a trickle.
There are unintended consequences of the low, flat yield curve globally, such as the negative impact on banks, which make the path of least resistance for yields to rise and yield curves to steepen. Banks make profits by borrowing short and lending long, so a flat yield curve eats right into their profit machine. It has been a decade since the last time the yield curve was this flat, and we are now exactly five years from the time when the yield curve reached its recent steepening peak. A flat yield curve is not conducive to the optimal functioning of bond markets. Either short term yields have to fall, or long term yields have to rise for yield curves to steepen to more normal levels. Barring a sharp, unforeseen recession, I suspect that the next bout of steepening will arise from long yields rising. This view is even stronger in Europe, where the ECB has kept short term yields negative, for what, as discussed below, is a substitution of monetary policy for fiscal wealth transfer from one set of European countries to another.
Let us start with the United States government bond market. Two-Year Treasury yields in the US are around 2.7% whereas thirty-year yields are at 3.10%. But the interest rate duration of the thirty-year bond relative to the two-year is ten times as large. In other words, all else being equal, for the same amount of interest rate risk one could buy a much larger amount of two-year treasuries and still be guaranteed principal redemption in two years.
Another way to look at this calculus is to compare today’s spot yield with the yields implied at some forward horizon, since what matters to investors is what the market is implying over the holding horizon. At a one-year horizon, the yield curve is implying two-year yields to be at 2.9%, and the thirty-year yields to be at … 3.12%! So what is baked into the curve is about a twenty basis point further flattening. In other words, choosing thirty-year bonds over two-year notes means that the investor has to be betting on a flattening of at least twenty basis points before he starts to profit from the curve. Extend this analysis out five years, and we can see that the yield curve spread of the forward two-year treasury yield and the forward thirty-year treasury yield is flat at 3.15%. Two-year treasuries are guaranteed to return their current yield of 2.65% if held for two years. Due to price risk, the same thing cannot be said for the thirty-year bond. Holding any long bond today may be like playing with fire in a munitions factory.
The situation in Europe and Japan is even more perverse due to the central bank purchase-driven negative yields in the very short end, which permeates into historically low yields across their yield curves and to the admittedly shaky peripheral countries. Even though professional bond market investors have become used to this “normalcy of deviance”, i.e. the fact that Italian, Spanish, and Portuguese yields are about the same or below the US, this situation is not normal. There is a fundamental difference between negative yields and positive yields. These two distinct yield regimes require us to think of bonds in different conceptual frames or “phases”. When bond yields are negative, the price of a zero-coupon bond by arithmetic is higher than par. This effectively guarantees a loss of principal and a buyer committing to a loss of return for return of capital. I call this the “bonds as insurance” phase. As yields go from negative to positive, as they did in Japan recently after being negative for most of 2016, there is a sharp transition of bond prices from insurance policies to investment assets. Let’s call this the “bonds as investments” phase. As such, they have to compete with other investment assets, and if they were to compete right now as investment assets, they would lose.
Central bank addiction to low yields in the face of robust growth can be explained in terms of non-monetary objectives. In Europe, where the countries are not part of a unified political or fiscal system, negative short-term yields play the role of a monetary subsidy of the ECB (European Central Bank) which transfers wealth from one country to another. Most of the long bond supply of Germany and other “safe” European governments sits at the ECB. Because of the lack of supply to satisfy index demand, long bonds are scooped up by investment funds to match the risk statistics of the bond indices that they track. As a small gift, they are provided “carry”, i.e. a percent or two of income as time passes.
In my view a percent or two of carry compensation is very skinny if the payback is a few tens of percent of potential price loss. In a very perverse way, the lower the yield and the higher the price, the more the demand increases, since there is no other way to match the duration metric of the index. In Japan, low yields help maintain a growing mountain of debt that will quickly become unserviceable if yields are allowed to move up sharply. Of course, as a sovereign, Japan can continue printing more Yen which will eventually find a way out of Japan and into other countries’ assets. The recent talk in Japan of moving the yield target up to 0.11% caused a fit, as global bond markets all sold off sharply. In the US the current level of low long-term yields despite Fed interest rate increases are explainable both by money flowing out of Japan and Europe looking for yield and by a late rush to lock in liability immunization with attractive tax deduction benefits for pensions, among other factors. These are all reasons to hold an investment asset at elevated prices for essentially non-economic reasons.
While the world’s central banks have been able to justify a world of extremely low yield and massive accumulation of bonds due to the lack of inflationary pressures — for now — the fact remains that in a competitive market for profits, these distortions cannot continue forever – the market will force the long end of the yield curve to a price that it considers “fair”. Clearly central banks have more ammunition than a private investor in the short run, but if banks are to survive and government debt has to clear, yields have to reflect this in the long run. I am aware that the long run can be very long, but it makes little sense as an investor to lock in capital with the guarantee of receiving less capital back in the future. Perhaps it takes a challenge to the existing order from a non-monetary source, as in recent Presidential tweets, to set off the chain of events that brings the long term into the short term. Given the complacency in the global bond markets, the path from here to there is likely to be sharp, sudden and breathtaking.
What about the stock market? The money that will come out of bonds has to go somewhere. In the short run, the likely place for this money to find a temporary resting place is in the deep equity markets of the world. Despite high prices, theoretically there is still room above, though the circumstances dictate selective prudence and tactical readiness to move back into short duration fixed income assets. One nice benefit of short duration assets such as the Two-Year Treasury is that not only does it provide a healthy 2.7% yield, but also provides liquidity against sharp equity market drawdowns.
In terms of relative pecking order, the US equity markets will likely take the lead since they are the most liquid and have the ability to take in gigantic flows. Further, in a world of currency wars and a generally business-friendly fiscal government policy, companies that are more domestically focused are likely to be better investments. Steepening yield curves are also good for the financial sector as discussed. On the other hand, tightening financial conditions will likely be negative for “spread” and “carry” markets, such as emerging markets, high yield credit and technology. While it’s hard to be too bullish on any asset class and any subsector of equity markets after ten years of a bull market, unfortunately these choices seem the better than piling into low or negatively yielding bonds. Taking risk while being well protected on the downside is a theme that I have highlighted before, and emphasize again.
Also note that after the VIX debacle of February, the volatility in equities has oscillated back to recent lows, but volatility in the bond markets has literally crashed. This has happened because of a number of reasons. First, macroeconomic volatility is at all-time lows, and in a world of low macroeconomic volatility and central bank buying of fixed income assets, there is the perception that bond markets cannot fall much. The corporate stock buybacks that have supported equity markets have a close parallel in the central bank driven buybacks in the bond markets: the government issues debt (bonds) with one hand while the other hand of the government buys back the very same bonds.
If and when the government bond “buyback” cycle reverses, bond market volatility will spike, bond yields will jump, and asset classes levered to future borrowing will suffer. Asset classes most sensitive to discount rates will be the first ones to lose and bond markets, by definition, are all about the discount factor. Second, “shadow financial insurance”, i.e. the selling of options to generate income, which last year was the proximate cause of the low volatility in equities, has found its way into all asset classes, and into bond markets in particular. All of this makes protection strategies, i.e. purchase of options on both stocks and bonds, extremely cheap.
Putting these broad thoughts together, a simple, practical asset allocation today might consist of three main pieces. First, for growth, it may have roughly half in developed market equities, especially focused on small capitalization stocks and sectors that would do well in environments where yield curves across the world steepen and cross-border disputes escalate. This could be supplemented with a core holding of short maturity Treasuries that provide a decent, credit risk immune yield north of 2.5% or so with guarantee of principal. Finally, and depending on drawdown tolerance, some of this yield might be spent on protecting the downside of the risky equity part of the portfolio. In my view, the divergence of global central bank policy has created these allocation opportunities. Today investors can build relatively benign portfolios of equities while harvesting the yield from the safe part of the bond market as other parts of the bond market are becoming increasingly dangerous. While I have chosen to focus on the three core pieces discussed above, it should be noted that there are other asset allocation strategies that may also do well in the current market environment and may warrant consideration.
Any views expressed by Dr. Bhansali are solely those of Dr. Bhansali and do not necessarily reflect the views of LongTail Alpha, LLC, its affiliates or other associated persons thereof. This note was originally published on forbes.com on July 27, 2018.