A broken supermarket trolley bumps into Humpty Dumpty on Threadneedle Street

The mangled syntax, sophistry and “jobbing backwards” evident in the Bank of England’s Inflation Report is a wonder to behold. 

As Humpty Dumpty said in Alice through the Looking Glass “When I use a word, it means just what I choose it to mean – neither more nor less”, to which Alice replies “The question is whether you can make words mean so many different things”.

Having raised rates in November 2017 (the first rise since 2007) the Bank soothed fears by stating that any further moves would be “limited and gradual”.  In the February Inflation Report the Bank delivered an uppercut to the solar plexus of financial markets by changing the message to “earlier and faster”. This, not unreasonably, led money markets to price a high probability of a rate rise in May. Subsequent weak data and comments from Governor Carney reduced this probability, so that today’s no change decision was generally expected.

If it was expected, what’s the problem?

Well, central bank messaging and consistency is worth real money. The risk premium that attaches to UK assets will be a function (amongst many other things) of confidence in institutions, predictability, and some sense of the framework that the central bank is following. Since September 2017, following Bank of England communication has been analogous to walking behind a fellow shopper whose supermarket trolley wheels are defective.

Where the Bank of England will weave next is increasingly difficult to tell. Our view is that the 0.1% Q1 GDP number likely overstated the weakness of the UK economy and was significantly depressed by bad weather. The path to a Brexit transition deal remains bumpy, but in the central case that such an agreement is reached, the UK economy is likely to grow at or above trend in 2018.

If the economy does rebound and the Bank does not make another swerve from “data dependency”, current market pricing of future interest rate rises would appear to be too low.

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Have you checked how many negative yielding bonds you own?

One of my favourite publications of the month comes from JP Morgan and has the catchy title of “Negative Yield Index Monitor” – I know, I should get out more.

This publication provides a snapshot of the weird and wonderful world of global bonds and the prevalence of negative yielding bonds. The current outstanding market value of negative yielding government debt stands at $10.1trn – that is even more than a pocketful of Bitcoins, but watch this space.

This will be the highest year-end total of negative yielding bonds on record, compared to $9trn at the end of 2016 and $6trn at end 2015. So in a year when global central banks have reduced the degree of support they provide, the Federal Reserve and Bank of England have raised interest rates and the European Central Bank and Bank of Japan have reduced the scale of their easing, the amount of negative yielding bonds has actually risen.

This is a key reason why we believe active management of fixed income portfolios is key at this point in the cycle. A passive allocation could leave you a prisoner to the growing drag of negative yielding bonds.

Leonardo da Vinci, Paul Newman, QE and relative value

On Thursday (26th October), Mario Draghi outlined the ongoing monetary easing that the European Central Bank (ECB) will provide to the European economy.  He announced that the ECB will buy assets at a rate of €30bn per month in the first nine months of 2018 (at least) which is a reduction from the current pace of €60bn per month. 

Another, and perhaps not so tendentiously related, event also occurred yesterday.  A Rolex watch that had been owned by the actor Paul Newman made the highest price ever achieved for any watch at auction. You were too polite to ask, but the watch was sold for $17,752,500.  No guarantee is made to its time-keeping.

Mario Draghi, as far as we are aware, did not buy the watch.  However, he and other global central bankers are involved in the process which has resulted in the present elevated level of asset prices.

The size of global central bank balance sheets is around $20trn, an increase of $15trn over the past 10 years.

In the first instance, central banks bought government bonds, then they bought corporate bonds and mortgage backed bonds, and the Bank of Japan has also bought equities.

For the sellers of those assets the money has to go somewhere.  Cash isn’t an option as low or negative interest rates are the norm.  The move into riskier assets and out of monetary assets into real assets has driven many markets to all-time-high levels.

So how does Leonardo relate to all this? A re-discovered Leonardo painting will be offered at Christies New York on November 15.  The painting had a hard life and suffered from unsympathetic restoration over the years.  As such it was not considered an original.  It sold at auction in 1958 for £45 and then re-surfaced in the US where it was sold as a Leonardo copy in 2005 for $10,000.  The estimate in the upcoming sale is around $100mn.

Sounds like a lot?  It is a lot.  However, at that price it would not make it into the top 10 prices paid for a work of art in the past ten years.

QE – the money finishes up somewhere.

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Why would any fool buy a bond with a negative yield?

On the 4th of July this year, the German government issued a bond with a 0% coupon with a maturity date of 7th October 2022. 

On its first day of trading this bond closed at a price of €100.78. Sharp-eyed readers will have spotted a potential flaw here. On day one an investor would have to pay €100.78 for a bond that pays no coupon each year between 2017 and 2022 and on the 7th October 2022 will repay you €100. This equates to a yield of -0.15%.

I suppose a 0% coupon makes filling in a tax return easier, but why would anyone do this?

Well in the Alice in Wonderland distortions of the European bond market, sometimes believing six impossible things before breakfast is exactly what you should do.

This bond touched a new high closing price yesterday of €101.86, equating to a yield of -0.36%.

An investor who bought on July 4 will have enjoyed a total return of 1.07% in a two month period. Also for a sterling-based investor, the euro has appreciated by around 5.8% against the pound since July 4. So a sterling investor who bought a negative yielding bond with a 0% coupon would have achieved a near 7% total return since early July.

The Mad Hatter invites everyone to tea.

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“How’s that reflation stuff working out for ya?”

In the pantheon of American leaders, Sarah Palin does not obviously spring to mind.  Nonetheless she did have a good barb at then President Obama in the early stages of his administration when the economy wasn’t going so well when she asked a tea party convention in Nashville (aren’t you sorry you missed that?): “How’s that hopey, changey thing working out for ya?”

From a government bond market perspective, reflation is everywhere but in the price.

A few charts illustrate the buoyant state of economic confidence.

Source: JP Morgan as at 30 April 2017

Global business confidence is not only high, it is coordinated with all of the major developed markets performing well.

This is mirrored in consumer confidence with a particularly marked rise in emerging markets – note the equity performance of luxury goods manufacturers such as Richemont and LVMH for a cross-check on this.

Source: JP Morgan as at 30 April 2017

In this world, one would expect higher government bond yields, steeper yield curves and higher breakeven rates of inflation.  Now admittedly if we take mid-2016 as a starting point all of these conditions are fulfilled.  However, recent government bond price action suggests at least a pause in the “reflation stuff”.

The Federal Reserve started the current rate rise cycle on December 16, 2015.  On that day the 10yr US bond yield traded at 2.29%.  There have been two further increases in rates since then and more are expected.  The current 10yr US bond yield is 2.29% (spooky, no?)

A flattening of the yield curve tends to be a late cycle phenomenon.  The gap between the yield on US 2yr notes and US 10yr bonds is around 102bps.   This spread is close to the flattest it has been since the financial crisis.  Government bonds are anticipatory assets, they provide signals of expectations for future economic activity.

The breakeven rate of inflation is the gap between the yield on an inflation-protected bond and a nominal bond.  The spread provides an indication of the balance between inflation and deflation fears.  In early 2016 deflation fears dominated and this spread fell to around 1.12%.  This spread did react in mid-2016 in anticipation of a stronger global upswing.  However, this spread peaked just below 2.10% at the beginning of 2017 and the level is now 1.84% – not a massive endorsement of “reflation stuff”.

Can your gilt tracker do this?

The Bank of England re-started its gilt buying operation in August 2016.  This action was taken to provide insurance against an anticipated slowdown in the wake of the EU referendum vote.  As part of the QE programme the Bank also re-invests the proceeds of the redemptions within the Asset Purchase Facility.  The re-investment of the proceeds of the gilt that matured in January 2017 will be completed on March 13.

The impact on the gilt market of the Bank of England’s buying has been significant.  The Bank of England buys bonds in three maturity bands, 3yr-7yr, 7yr-15yr, and everything greater than 15yr.  However, the Bank has a self-imposed limit that it will not own more than 70% of any one gilt.  This restriction means that in the 3-7yr bucket, of the ten bonds available only one is over the 70% limit.  In the over 15yr bucket all nineteen bonds are available to purchase.  However, in the 7-15yr bucket, of the seven bonds only three have been available for the Bank to buy.

This has the result of distorting the price of bonds with very similar features.  For instance, the 2.25% 2024 gilt has been available for the Bank to buy but the 5% 2025 gilt has not.  These two bonds have an identical duration, that is, price sensitivity to changes in yield.  The 2024 gilt at one point offered 8bps more yield than the 2025.  At the moment it offers around 5bps more yield.

An active fund can oppose these distortions created by central bank actions and pick-up the extra yield for no extra risk.

Can your gilt tracker do this?

Very low government bond yields seem much more likely than higher yields

We don’t share the common view that government bond yields are heading materially higher. Indeed, very low government bond yields seem much more likely than higher yields.

Data from the National Bureau for Economic Research says that the current 90-month economic expansion from the trough of June 2009 is the third longest since they began measuring such things in 1854. But just because it has been a long cycle, does not mean it must end. And it is worth investigating what actions central banks may have to take to respond to any future downturn.

The US Federal Reserve is still raising rates, but I doubt it will be able to raise Fed funds above 2% without provoking a significant slowdown in the economy (the current rate is 0.75%). So any future easing will have very few interest rate ‘bullets’ to fire and even more ‘unconventional’ monetary easing would be likely. In this context the risk of negative US rates seems higher than the prospect of ‘normalisation’.

That is why we don’t share the common view that government bond yields are increasing significantly. The current 10-year US treasury yield is 2.4%. If the current business cycle runs for another three years it will be the longest expansion ever. The market pricing of the 10-year US treasury yield in three years’ time is around 3%. Unless business cycles have been abolished (and we don’t believe they have) the US will at some point experience an economic downturn. At this point the conventional tools available are likely to be much less than has typically been required in the past.

To read the full article, click here: http://kamescapital.com/facing-up-to-the-next-us-recession.aspx