13th February 2015 by Chris Iggo
QE has reduced term risk premiums in a number of government yield curves. That means to be a long term investor in government bonds you either “have to be one” or you have to believe that interest rates will not go up very much for a very long time. If you don’t believe in secular stagnation and “lower for longer” then you might be sympathetic to the “yield give-up” rather than “yield pick-up” approach suggested by my close colleague Nick Hayes, manager of the AXA WF Global Strategic Bonds. That means money markets might be more attractive than government bonds. Of course, it depends on the timing of rate hikes and how far they go. Listen to Federal Reserve (Fed) officials. They seem to be preparing the market for lift off in the middle of the year. Instead of “lower for longer” a more popular twitter hashtag might be “#1994 redux”. In the meantime, if there is good news from Ukraine and Greece and from the economic data then high yield, as well as equities, should continue to outperform.
More QE – The Swedish Riksbank became the latest central bank to join the QE party this week. It announced that it would buy 10billion krona of government bonds and also that it was reducing its deposit rate to -0.10%. All of continental Europe is now squarely engaged in the fight against deflation with negative interest rates in the Euro Area, Switzerland, Denmark and Sweden. Central banks are doing the best to discourage investors from buying government bonds by generating low or negative yields in the hope that re-investment and new capital will instead be directed to the real economy through bank lending or increased investment in corporate bonds and equities. For smaller European economies like Denmark and Sweden, the proximity to and importance of the euro area means there is little choice than to the follow the ECB’s easing in order to avoid an unwanted rise in the value of their currencies against the euro. It does look a bit like a currency war and the obvious trade in the currency markets is to be long the US dollar. We just need to hope that the US economy is strong enough to allow some global re-balancing of growth and inflation through the FX markets. Some observers are concerned that dollar strength will be negative for the US and this will prevent the Fed from raising interest rates this year. So far this does not seem to be the case as the economy is benefitting from lower oil prices and strong jobs growth. Indeed, a number of Federal Reserve officials have made comments in recent days suggesting that the Fed itself is still eyeing a first increase in rates around mid-year. Don’t fight the Fed.
Deflationary bias – However, QE-mania still dominates bond markets and it was interesting that the Bank of England governor, Mark Carney, mentioned that the Bank could still cut interest rates and re-start QE if inflation in the UK was persistently below target. This “deflation hedging” bias from central banks is likely to persist, at least in the short term, as annual inflation rates will fall further into the spring. This mostly reflects the fall in oil prices. The year-on-year decline in oil prices will not turn around for some months and this will mean continued downward pressure on consumer price inflation rates. It will be difficult to tighten monetary policy when inflation is well below target so the pricing of monetary tightening will depend on the ability of central bankers to persuade markets to look through the oil price effect – which is transitory – and to think about what will happen to inflation in response to reduced spare capacity. This is only really relevant to the US and the UK in the foreseeable future, and keeping an eye on wages and core inflation will be very important through to the summer and beyond. A nasty bond market sell-off would surely take place if suddenly headline inflation jumped higher as the negative effect from oil prices fell out of the annual rates. The Fed will be careful, having taken such a long time to get to the “take-off” point, not to be seen to have fallen behind the curve.
Bond bubble? – For now though, bond yields remain very low despite a bit of a sell-off in the last week in response to another strong employment report. We held a conference for clients in London this week and the theme of the bond presentation was whether or not there is a “bubble” in the fixed income markets. Long-term readers will know that I struggle with the concept of a bubble in bonds because the term usually refers to some kind of euphoric buying of financial (or real) assets in the hope that investors will make excess returns. For bonds to be in a bubble we have to think about it in a different way. Investors should favour bonds when they expect negative returns in other assets. Rather mischievously, we compared the current government bond market with the Nasdaq rally of 1999. The comparison is a stretch but if you play around with the data in an excel spreadsheet you can create a nice chart overlaying the US Treasury total return index of the last couple of years with the Nasdaq index in the two years leading up to the bursting of the technology bubble. The point is that a narrative takes over in markets that can lead to valuations becoming very dislodged from fundamentals. In 1999, there was euphoria that the world was going to change for the better because of technology. Today, the narrative in some quarters – importantly amongst central banks – is that the world has been changed for the worse because of the financial crisis and the deflationary forces that it unleashed. In 1999 taxi drivers were spreading the word about which dot.com stocks to buy. Today, Mario Draghi tells us that he will do “whatever it takes” to save the euro and prevent deflation.
Bond bulls believe in secular stagnation – Investors that remain really bullish on bonds have to also believe the deflation story, or at least believe that the central banks will continue to believe the deflation story, and set policy accordingly. There is a reasonable amount of sympathy with the secular stagnation argument that concludes growth and inflation will remain low because of damaged balance sheets, excess savings and ageing demographic dynamics. The policy response to the secular stagnation theory has to be deeply negative real interest rates which means, until inflation picks up, deeply negative nominal interest rates. So QE will continue and negative interest rates will become common. It is only if this is your macro narrative that you would continue to buy high quality bonds in the hope that you can still get the kind of returns that have been delivered in the market over the last 5 years. Clearly, in a buy and hold to maturity strategy you will lose money if bond yields are negative, but in a marked-to-market active strategy you could still get positive returns if yields fall further.
Has the term premium gone? – Part of that narrative has to be an expectation that central banks will not raise interest rates at all, or not by very much, over a very long period of time. Only if you believe that can you still believe that there is a term premium in fixed income markets. Essentially, investors in bonds hope to get a return higher than the risk-free rate though becoming exposed to term risk premium (future interest rate risk) and credit risk premiums. You buy corporate bonds and assume credit risk if you think the credit spread more than compensates you for the losses that would accrue from default. You buy government bonds (rates) if you think that the current level of longer term interest rates more than compensates you for the risk of future increases in short term rates. If you knew for sure how short term rates would evolve over the next 5 years and the current 5-year bond yield was such that it more than compensated you for those future interest rate increases, you would buy the 5-year bond and profit from the term premium – the difference between current forward rates and expected further short term rates. The problem is you don’t know what the level of future short term interest rates will be and can only make a judgment, based on forecasts of monetary policy, that the current yield curve either under or overestimates future levels of short term rates.
#lowerforlonger or #1994redux – So today, to believe that there is still a positive term premium in rates markets, you have to believe that monetary policy will not be tightened as much as is currently discounted in the yield curve. Using the Bloomberg forward curve function we can observe that the US Treasury curve suggests that the peak in 3 month interest rates (the proxy for Fed policy) will be no higher than 2.4% in the next 10 years. If you think the market is good value or want to extend duration in this market your own forecast has to be that the Fed will tighten even less than what is implied. In reality, I doubt anyone believes this strongly enough to buy and hold longer term Treasury or Bund or Gilt debt, unless they have to for regulatory or liability matching reasons, and those that are more trading inclined might buy it to access the term premium in the short term through carry and roll down strategies; basically betting that the short rates won’t go up for some time. The risk is that they might.
Credit more attractive than rates – It’s risky though. If the term premium is really low or negative i.e. short term interest rates will rise more than is currently implied by the yield curve, long positions in bonds are subject to downside risk should rates move up quicker than expected. The longer you are on the curve, in terms of maturity exposure, the greater the risk to your portfolio should rates move higher. In our view the opportunities to benefit from term premiums have all but disappeared in most markets. That doesn’t mean that tactical long duration strategies won’t work and, as I mentioned above, we are probably going to move into a period of even lower inflation prints in the next few months that could drive longer rates down even more, but the long term value in rates curves has gone. We are less negative about credit because there is still a credit risk premium and returns from credit spread should still be in excess of the risk free rate. So far this year, investment grade credit has delivered positive excess returns relative to government yield curves. There is still some credit risk premium to harvest.
Sound bites – One of the great things about my job is the opportunity to work with people who are really smart in terms of their technical knowledge, their market awareness and their ability to communicate on investment ideas. The comments about term and credit risk premiums were inspired by a conversation I had with a member of my team who also presented at our client conference in London. Many of you will know Jonathan Baltora, one of our inflation and rates specialists and manager of the AXA WF Universal Inflation Bonds. The conclusion about the level of yields also brings to mind a comment made by another of my colleagues, Nick Hayes at the same conference. If, broadly speaking, the reason for investing in bonds is to beat the risk-free rates (cash) and we now believe that level of yields does not provide enough of a term premium to compensate you for future rate risk, then a bond strategy in the near term should be characterized by “yield give-up” rather than “yield pick-up”. It’s a similar sentiment to the one expressed by our money markets head in Paris who recently put the case forward for investing in money market funds in the euro area on the basis that you know how much of a negative return you are going to get in money markets, but you don’t know how much of a negative return you could get in bonds.
Inflation or a rates increase needed to burst the bubble, so not yet – Going back to the concept of a bubble, the obvious question to ask is what causes it to burst? We tried to “google” to identify if there was a single event that caused the Nasdaq to crash in 1999 but there was nothing obvious. It seemed the market just caved under its own weight as investors started to realise that companies were very unlikely to generate the kind of earnings that were being priced in. What about the bond market? Is it likely to cave under its own weight? It’s hard to see that with central banks dominating things. What needs to change is the inflation outlook and the central bank narrative. Neither is likely in the first half of the year. H2 could be different though. In the meantime, our preferred hunting ground for risk premiums continues to be in high yield in both Europe and the US.