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.
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”.
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?
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