Macro

Over recent weeks the trade war ebbed and flowed, Hong Kong erupted in more protests, both the UK and Germany teetered on recession, New Zealand’s central bank stunned markets by dropping its benchmark rate by 50 basis points, Thailand also surprised by cutting rates and India’s central bank lowered its rate by an unconventional 35 basis points.

However, away from that which is focused upon by much of mainstream commentary is our observation that the world’s bond markets have dived deeper into a very dark space.

It is my view that whilst bond markets are not acting rationally their price behaviour can be explained. Importantly, whilst the inevitable bond crash can be delayed it won’t be stopped.

Let’s start with an opening observation of the formerly hopeless Greek bond market. Over recent months Greek ten year bonds have rallied to a record low yield (for them) of just 2.1%. At the shorter maturity, Greek 2 year bonds now yield just 1.4% which is lower than the yield on US 2 year bonds (1.65%).

This is extraordinary because Greece has a Government debt-to-GDP ratio of 181%, youth unemployment of 40.4%, and its nominal GDP has shrunk by 23% over the past decade. Greece has defaulted eight times and has been in default for half of its time as an independent country. Logic would suggest that a 2% return on Greece bonds is not enough for a rational investor to accept.

However, the Greek bond market is not an isolated case, for most of the world’s bond markets are transitioning through the greatest asset price bubble of all time. Many “emerging-market” debt instruments currently have a negative yield. Examples include Polish government debt of up to seven years’ maturity and all of the Czech Republic’s euro-denominated debt.

Further, there are several European corporate junk bonds that are trading with negative yields where investors are in effect paying the company for the privilege of lending to them.

But we should not only consider low quality debt issuers. A glance at Austria’s historic 2017 issue of 100 year bonds with a 2.1% issuance yield, now sees this bond trading with a yield to maturity (only 98 years to go) of just 1.2%. Not surprisingly, Austria is now issuing more 100 year bonds, while the asset managers who bought the first tranche bask in the delusion of thinking themselves as being very clever.

The asset managers placing these investments (or bets) on behalf of their clients must believe that European inflation will average less than 1.2% over the next 100 years. Or they may think that Europe is entering an unprecedented 100 year recession. I suspect that they are not thinking at all, but rather they are combining momentum trading by front running the European Central Bank (ECB) with a desperate chase for yield – any yield!

However, in their defence, they are dealing in markets completely compressed by unrelenting and excessive Quantitative Easing (QE). Further, they possibly perceive that the ECB is caught in a manipulation strategy with no way out.

The chart below shows by how much yields (in this case 5 year bonds) have crunched under the steady pressure of European QE over the last five years.

I would suggest that rather than the European bond market predicting a recession (which many commentators still claim is why bond yields are falling), bond yields have merely succumbed to the unrelenting wishes of the European Central Bank (ECB) to push down the cost of government debt. This will become clear when we examine the US situation below.

Low negative or zero interest rates mean that the likes of Greece, Italy and Portugal cannot default on their government debt even though they have a lot of it.

By forcing down the cost of bond debt, the ECB has allowed most of the major Eurozone economies to maintain expansionary budgets (fiscal deficits) without any concern that they might not be able to service the expanded level of debt.

While not adopting a QE program (yet), I believe that the Reserve Bank of Australia (RBA) is adopting a similar strategy in dealing with our excessive level of household debt. That is, the RBA is attempting to hold the cost of mortgage debt down, so that it either can be paid back or accessed and serviced by new entrants to the market. To achieve this result it requires declining cash rates which ultimately feeds into lower bond yields.

Whether the ECB or RBA succeeds in their strategies is open to conjecture. However, what should be understood is that the owners of government bonds will have to exit their investments at some point to crystallise their windfall returns. Further, because the yield (and potential return) on these assets is rapidly disappearing. The cash required to meet liabilities, the main purpose of bond investments (for example pension payments) will only be met by selling or liquidating bonds. I perceive that this is a massive problem developing across Europe which can only be solved by perpetual QE – much like that which has been adopted in Japan.

The European (and the Japanese) bond markets are now in a very dark space with a growing potential for massive losses. Of course, bond managers won’t admit this, nor will they acknowledge that their only hope is that the central banks continue to buy up all government bonds on issue. At that point we won’t need bond managers!

Meanwhile US Government debt is ballooning

Maybe I was a little harsh on Greece (above), because the US fiscal position continues to deteriorate under the Trump administration. After ten months (ended July), the 2019 US fiscal deficit is greater than the total deficit of fiscal 2018.

The Trump tax cuts effectively broken the trajectory with the US fiscal deficit. It is now approaching levels seen during and immediately after the GFC.

According to recent US Treasury numbers, the interest expense alone on US public debt is on track to reach a record US$577 billion this fiscal year, more than the entire budget deficit of financial year 2014 (US$483 billion) or 2015 (US$439 billion). This year’s interest bill equates to 2.7% of estimated GDP, the highest percentage since 2011.

No wonder President Trump wants interest rates down in the US. He clearly wants the same benefits that are afforded by monetary policy to highly indebted governments across Europe and in Japan.

A 1% reduction in the cost of debt for the US government (currently about on issued US government debt) would lower the US deficit by US$200 billion. However, that will take many years to achieve as debt has to be rolled over, and the Trump Administration hasn’t got that much time left. The US election is in 15 months’ time.

This leads me to reiterate a forecast that I made late last year.

The US Federal Reserve (the Fed) will reintroduce QE as the US budget outcome deteriorates. President Trump has begun to coerce the Fed into cutting cash rates further, and the Fed will succumb and justify their decision by focusing on slowing world economic growth. Indeed, it is possible given the mess that has been created by both the trade war and QE, that the Fed may move quicker than many are currently forecasting.

While the world economic growth outlook looks poor for the coming 12 months, I cannot see how this justifies an allocation to ultra-low or negative yielding bonds and a panic out of risk or growth assets.

Let’s remember that negative Japanese bond rates have not pre-empted a decline in the Japanese equity market. The equity market hasn’t done much but it has achieved better cash yield returns then the bond market.

Further, I challenge the logic of now panicking or allocating into bonds due to a fear of recession. The reason I come to this conclusion is this. When there is a recession (and there will be) it will inevitably pass. It will not endure for very long – certainly not 100 or even 5 years. When it ends then the logic (if any exists) for negative yielding bonds will also end. Bond prices will then correct very sharply, and central banks will be forced to bail out the bond owners.

I am reminded of a conversation many years ago when Western Australia was in drought and Perth was running out of water. When asked “when the drought will end?” a rather savvy businessman of the time answered, “when it rains”. Sounds like a prediction for the bond market with the Central banks blowing the clouds away.



Comments

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Mr T

"Low negative or zero interest rates mean that the likes of Greece, Italy and Portugal cannot default on their government debt even though they have a lot of it." It's just so weird... although when i think this through, i guess they can default on the debt if they never pay the principle back? And boy could you do some awesome arb trades if you were issuing debt with a negative nominal interest rate! Fascinating article thanks.

Harry

John, good article. Please explain how central banks will bail out bond holders when a recession or depression starts when they are bankrupt not only financially but strategically . Aren't they the ones who created this mess and the addiction to what they call "growth" (actually destruction) at any cost. My guess is the merry go round will be forced to stop by some major event and all ledgers will be destroyed so we can start the destruction anew.

John Abernethy

Hi Harry I think you are asking - how will Central banks bail out bond holders in a recession? The answer is that they are doing it now, every day, and I predict that QE in Europe, Japan and soon the US will endure in some form for as long as you can see into the future. Cheers JA

Harry

I see John so they keep helicoptering money into markets until we need wheel barrows to carry the money for food purchases etc. I recal my first time in Vietnam years ago where the money you carried were called "bricks" due to the number of notes needed to buy simple items. Madness if you think this will go on forever as underlying discontent will raise its head as history shows us.

Matt Christensen

Thanks John!! Awesome article!! Question. If one were to lose complete confidence in the Global system (which your article helps lay groundwork on), and instead have confidence that the eventual de-basement of most currency values via future effective money-printing will see the real purchasing power of most traditional assets decay (from mostly frothy levels). Where would one invest for safety, aside from Gold and Guns? Obviously momentum and long-Duration Fund strategies are natural leveraged beneficiaries of the Trend, and QE-"benefits" while the confidence sustains. Can you think of any natural beneficiaries/strategies to win on the unwind (excl. obvious negative beta exposure / shorts)? Thanks.

Robert Goodwin

Sounds like the Titanic. Once more the suckers will transfer their wealth to governments. I can’t help but wonder how the investing in bonds that yield a negative rate is in the best interest of investors. It’s ultimately a recipe to lose wealth. Justifying it as a “mandate” for many funds doesn’t work for me. It shouldn’t work for anyone because it doesn’t make economic sense

John Abernethy

Thank you for the comments. As a hedge I am seeing some merit in holding gold as a proxy to negative yielding bonds. It seems to me that something that may make or lose value (gold) is a better option than something that is guaranteed to lose value if held to maturity. I think that is the key to understanding bonds and their owners. I think it is clear that the buyers of long duration bonds or negative yielding bonds do not intend to own them until maturity. It is a participation in the ultimate ponzie scheme that is controlled by central banks undertaking QE. As for the beneficiaries ( assets) when this unwinds? I am not sure what the beneficiary will be although the focus of QE in a bond correction may be transferred to using QE to stabilize other assets. This will not play out in a text book or predictable fashion. Regards JA