Monday 19 August 2019

Will surging bond markets fall to a dotcom-style bust?

SATURDAY INSIGHT

Uncertainty: The New York Stock Exchange. Financial markets have been forced to respond to an escalating trade war between the United States and China. Photo: Spencer Platt/Getty Images
Uncertainty: The New York Stock Exchange. Financial markets have been forced to respond to an escalating trade war between the United States and China. Photo: Spencer Platt/Getty Images
US president Donald Trump has imposed tariffs on China

David Chance

In the past week, the value of bonds that carry negative interest rates surpassed €15trn for the first time, a figure that is equivalent to the entire annual economic output of China, while Germany can borrow at negative rates across all bond maturities.

Ireland, too, briefly joined the sub-zero bond yield club for its 10-year issue on Monday and somewhere close to a quarter of all bonds globally now carry negative rates - forget being paid interest by borrowers, you pay to take those bonds.

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It is fair to ask whether the surge in bond prices and compression in yields represents a bubble in the making. It's a situation akin to the dotcom boom that led to the bust in 2001, which saw the Nasdaq market plunge 80pc from 5,000-plus points in March 2000 to 1,114 by October 2002, wiping out trillions of dollars in wealth.

Unlike the dotcom bubble, where company valuations were not tied to fundamentals - if anything, it was a badge of honour for one of the dotcom stars of the day, like Priceline, to actually make money - the bond market is firmly tied to the gloomy outlook for the world economy, as well as to other issues such as demographics and excess global savings.

Real short-term policy rates have plunged across the developed world - Europe, Japan, the United States, Canada and Britain - over the past 30 years, reflecting these dynamics.

Far from stepping in to drain the punchbowl as the Federal Reserve did with a series of interest rate rises, three in 1999 and two in 2000, the Fed is now cutting rates for the first time in 10 years. Meanwhile the European Central Bank failed to get off ground zero at all, and it now faces cutting deep into negative territory, as well as the prospect of restarting its bond purchasing programme.

London-based advisory firm Capital Economics believes this "new world order" in the global economy, central banking and bond markets is set to persist, and that it will not collapse in the same way that the chimera of the dotcom boom did.

"Overall, though, we expect equilibrium real policy rates to remain a lot lower than their averages of the past 30 years, even if they creep up in future in response, say, to an acceleration in productivity growth," said the firm's chief markets economist John Higgins.

US president Donald Trump has imposed tariffs on China
US president Donald Trump has imposed tariffs on China

"If we are right, 'risk-free' government bond yields are also likely to stay a long way below their averages of recent decades," he said.

There is a new economic reality, whose presence became apparent to most observers only after the financial crisis hit, which has pushed interest rates to their lowest levels of the past 150 years, with the world now living with stimulus from monetary policies that pushed rates to zero.

According to estimates from economists, real interest rates globally have fallen by two percentage points over the past 30-40 years.

At the same time as rates have ground lower, central banks have emerged as holders of massive amounts of government bonds, leading to scarcity for other investors.

According to data from Bloomberg, the Bank of Japan owns half of the country's sovereign bonds, while the European Central Bank has about 30pc of those issued by the 19-member currency bloc.

That effectively leaves one big bond market shoe to drop, the biggest of them all: US treasuries.

As of yesterday, the 10-year treasury was yielding slightly more than 1.695pc, a tad less than Italian 10-years and not much less than the 2.134pc on offer from Greek government bonds of the same tenor.

Yes, that's the same Greece that has just emerged from debt default and an International Monetary Fund programme versus the United States, a country that hasn't defaulted since the declaration of independence.

Global investment firm Pimco, which has €1.76trn of assets under management, reckons the US could soon follow suit into negative yields.

"Whenever the world economy next goes into hibernation, US treasuries - which many investors view as the ultimate 'safe haven' apart from gold - may be no exception to the negative yield phenomenon," Joachim Fels, Pimco's global economic adviser, wrote this week.

"And if trade tensions keep escalating, bond markets may move in that direction faster than many investors think," he wrote in a blog on the company's website.

In other words, the policies being pursued by president Donald Trump when he imposed tariffs on $300bn (€268bn) of imports from China, effectively putting every product the United States imports from the world's second-largest economy under punitive duties, will cause a renewed leg down in investment and hiring, cutting demand for funds even more and thus depressing interest rates.

"Against this backdrop, the financial history of the last decade is littered with central banks that either kept the 'money' rate of interest above the 'natural' rate or tried to raise it too early (the ECB in 2011) or too far (the Fed in 2018)," Mr Fels wrote.

"Both were punished by market forces and have had to reverse course," he noted.

It now appears that the 'high' real short-term interest rates that we experienced in the 1970s and 1980s were the aberration and that it will take a great deal to shift interest rates from their grind ever lower, even though the drop in real rates in the crash a decade ago was greater than that experienced in the Great Depression of the 1930s.

Just a few months ago, there was surprise in financial markets and among economic commentators when the Austrian government sold another €1bn into a 100-year bond issue at a yield of 1.71pc, after selling an initial tranche of €3.5bn at 2.1pc just two years earlier.

The yield on those 100-year bonds is now just 0.799489pc. To use market parlance, the investors who bought into it 'made out like bandits' and it looks like there is more to come.

Irish Independent

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