Thursday, September 1, 2016

Unintended Consequences I - The Bond Market

In this multipart series, I will take a look at the unintended consequences of the ultra-long period of near-zero or negative interest rates.  In part one, I'll look at the impact of central banks on the bond market and how that will impact investors.

According to an analysis by Tradeweb for the Financial Times, the value of bonds yielding below zero reached $13.4 trillion in the early part of August 2016, a concept that would have seemed absolutely absurd two short years ago.  From a central bank perspective, it certainly looks like a race to the bottom; central banks, with the exception of the Federal Reserve, seem to be trying to outdo each other when it comes to lower interest rates.  This has forced investors into higher risk junk bonds and  very long-dated government bonds in an attempt to squeeze out even a modest positive return on their investment.  In addition, it has also forced investors into the stock market, a move that has pushed up equity prices to what are likely unsustainable levels, a situation that could prove to be quite painful when markets readjust to values that better reflect the fundamentals of the weakening global economy.

It's largely the world's central banks and their seemingly insatiable demand for government bonds that have driven yields into sub-zero or near-zero territory.  Recent moves by the Bank of Japan and the European Central Bank to escalate or continue their quantitative easing programs are symptomatic of the monetary delusion facing the world's central bankers.  They actually believe that their easing programs will ultimately keep the global economy from collapsing into the Great Recession Part II.

As we know, bond yields act inversely to bond prices; as demand for bonds rises, prices rise and yields drop.  As I posted here, contrary to what common sense would tell us, there is actually a shortage of "ultra-safe" United States sovereign debt (please note the quotes around ultra-safe).  With the Federal Reserve and other central banks demanding more and more government bonds as part of their moves to stimulate the moribund global economy, bond prices have risen to levels that are, over the long-term, quite likely just as unsustainable as today's stock prices.  My suspicion is that the actions of the world's central banks have created yet another asset bubble in the world's bond markets, a belief that is backed up by a sampling of the world's Certified Financial Analysts.

According to the Nasdaq, a financial/economic/market bubble is:

"...a market phenomenon characterized by surges in asset prices to levels significantly above the fundamental value of that asset."

Here's the key part of their definition:

"Bubbles are often hard to detect in real time because there is disagreement over the fundamental value of the asset."

Basically, investors don't see the asset bubble "bus" coming until it's already run over them.

Let's go back to the global fixed-income market.  A recent poll by the CFA Institute (Chartered Financial Analysts) looked at the following question:

"Are any of the following global fixed-income markets in bubble territory?"

Here are  the responses of 815 poll participants:

Of all respondents, the largest segment, at 30 percent, believe that all bonds are in bubble territory.  An additional 24 percent believe that there is a bubble in sovereign bonds and at least one other class of bonds, either high-yield bonds or investment-grade corporate bonds.  Only 13 percent of respondents believe that there is no bubble in any class of fixed-income products.  As we all know (or should know), in the world's financial markets, perception generally becomes reality and this analysis is particularly sobering.

This is a very, very sobering analysis of the state of the global fixed-income marketplace, particularly given that fixed-income investments have been the multi-generational investment of choice when investors are looking for a safe haven that has, historically, paid a guaranteed and positive yield.  The bursting of this potential bubble could be extremely painful; according to an analysis by Fitch Ratings, a return to the yields of 2011 could see the global bond market lose $3.8 trillion in value.

Let's close this posting with a quote from the CFA Newsbrief:

"Most investors recognize the vast power that central banks wield but, by and large, disagree with the wisdom of their policies. In order for the world to return to market pricing of bonds, there has to be a catalyst. The power of the central banks must be more than offset by something else. There has to be a fundamental wave — either positive or negative — to counteract it, or a political wave to change it."

Everything always reverts to the mean and the reversion to the mean for the world's fixed-income markets will be an extremely painful experience for investors who are currently satisfied with a negative yield because they think that the capital that they have invested in their fixed-income investments is "safe".

1 comment:

  1. Till the painful experience is delivered to the investors, the guys who are waiting for it to be delivered (like me) are having an equally painful experience. I am just biting the bullet because I am convinced the central bankers are not going to succeed in getting the growth that is needed for this massive experiment.