RMG Investment Bulletins
Core G7 bond yields are trading at their lowest level this year. Nearly every strategist/commentator predicted that bond yields would rise this year leaving the consensus surprised by this year's performance. We have to wonder whether bond markets are improving because everyone has been underweight and there has been a significant short squeeze in a market where liquidity can be an issue, especially for large investors. Alternatively, the current low yields pose a more fundamental question for economic growth assumptions.
As we have said in recent weeks, there is no doubt that the US economy will rebound in Q2 after a disastrous Q1. However, there are doubts about the Chinese, European and Japanese economies. At the same time, we know that central banks will either maintain zero rate policies for a long time (US and UK) or are even looking to increase stimulus (Europe and Japan). Low growth together with generous central banks should be supportive of the bond markets so are low yields a concern over future economic growth?
We can't help but look at Europe ex. Germany and remain concerned about the lack of growth. Despite plunging bond yields, a retreat on fiscal austerity and significantly positive swings in business and consumer sentiment, Q1 GDP was negative in Italy, Holland, Finland and Portugal and was flat in France. Spain was an obvious bright spot and Greece also managed to generate some growth, but generally across the EU there remains a lack of domestic growth drivers in what should be a relatively decent environment.
Despite the disappointing growth story in Europe, the biggest threat to global growth (and global capital markets) remains China. The official data is now showing a marked slowdown in new construction and home sales which will dampen economic growth. Land sales are also falling and this impacts local government revenues and therefore future growth. Most worrying, however, are actual declines in property prices which have been seen in all but tier 1 cities. With property widely used as collateral for many borrowers, any decline in collateral values in a highly leveraged system has the potential to be destabilising. Of course, many believe that authorities will simply do whatever it takes, and perhaps this will prevent systemic issues from arising in the short term. However, any stimulus to prevent short term pain will surely only delay an inevitable unraveling of a leveraged system that simply does not generate sufficient revenues to service the debt. In Hyman Minsky model terms, a large portion of debt is now of the ponzi type (i.e. requires ever higher asset prices for full repayment) and this is simply not sustainable in the long term.
And so back to whether bond yields are posing a fundamental question over economic growth assumptions. In the big picture, we think that global growth could very well disappoint and that G7 government bond yields will remain low. However, at 2.5% for US and UK 10 year bonds and 1.3% for German Bunds, the low growth environment we expect is beginning to be priced in. At some point, the shorts will have been squeezed enough and yields in the US and UK may rise a bit as US economic growth rebounds in Q2. As indicated in the chart above, in the short term we expect yields to find support in the short end at or just below current levels.
As for other assets, equities remain mostly range bound with major indices nudging the upper boundary and secondary indices like mid and small caps nudging the lower boundary. We have been at pains recently to explain our thesis that equities are adjusting to changes to the low growth/high liquidity equilibrium that was so bullish last year. Simply put, we continue to believe that equities are strenuously overvalued and the risk/reward ratio is poor in the short term and dreadful for long term investors. However, nobody cares about this until prices are heading lower, although we do get the feeling that both bulls and bears are becoming frustrated by the sideways action this year.
Overall, we get the sense that markets are extremely complacent at the moment and this can be seen in the chart below of equity and fixed income volatility. At some point, volatility will increase because low volatility is always followed at some point by high volatility (and vice-versa) and when volatility rises, bad things happen and investors get hurt.
Before we answer our own question, perhaps we should try and understand why bond yields are rising. Is it because of faster growth expectations that will lead to a quicker removal of the current extraordinary policies? Is it a sign that the market is beginning to get worried about future inflation? Is it because investors are now demanding a greater term premium (for whatever reason) for holding longer dated securities? Or is it simply a reflection of investor psychology with investors dumping the underperforming asset and switching to the outperforming asset (in this case equities)? Most likely a combination of some or all of these factors.
We sit firmly in the camp that believes economic growth will remain relatively low for some time yet. We also sit in the camp that believes that inflation will remain subdued and that QE is not generating greater inflation because the FED's newly created reserves sit idle in the financial system (the only inflation being created here is asset price inflation -equities and housing). With weak growth and low inflation, nominal GDP growth will remain low by historical standards.
As can be seen from the chart below comparing nominal GDP and 10 year bond yields, the correlation is quite clear from a big picture perspective. With both nominal GDP growth and the 10 year both at 2.9%, perhaps the recent rise in bond yields (and slowing in the rate of economic growth) has brought the 10 year bond yield back to some sort of fair value.
During the 1960's and 1970's nominal GDP generally exceeded the 10 year yield - a period generally associated with rising inflation. The reverse was true in the 1980s and 1990s - a period generally associated with falling inflation. Since the turn of the century, there has been less of a clear signal. Perhaps, as a very, very rough rule of thumb, we can use nominal GDP as a guide to where longer term interest rates should be - I am sure that bond market purists will take some issue with this, but we are purely trying to illustrate that 3% may well be around fair value for bond yields if nominal growth is 3%.
A direct impact of higher bond yields (if sustained) is that debt will be more expensive to service and this will most likely be a headwind to growth. The chart below, courtesy of Bank of America, shows outstanding credit market debt relative to GDP. Clearly, debt has had to continue expanding at an ever faster rate than GDP just to keep GDP growing. If servicing this ever growing debt pile starts to increase (even from the current low level) then the greater amount of income is taken away from consumption and investment. We would also note (as seen in the next chart below) that yields have in fact risen since QE2, and so even if the FED wanted to contain long term yields, perhaps they are beginning to lose a bit of control now.
It seems to us that the FED policy of QE is increasingly being questioned, with even President Obama clearly stating that he does not wish to see policies leading to financial bubbles. If the FED is having to stop QE because the costs are beginning to outweigh the benefits and there is less support for it in both economic and political circles, then we have to try and understand what may happen when QE ends.
The chart below illustrates the FED's balance sheet and the 30 year mortgage rate. We have illustrated the start and end to balance sheet expansion (since QE2) with the green vertical lines and illustrated that the 30 year yield has risen during these periods (green arrows). In fact, as illustrated by the red arrow, the 30 year mortgage rates has risen since QE2 started. Conversely, when the FED has stopped expanding its balance sheet, yields fell.
Obviously, using only one example of the FED ending its balance sheet expansion to show that yields subsequently fall is hardly a robust sample size, but is all we have to work with. Perhaps what we should consider is that new rounds of QE have boosted the economy temporarily for a couple of quarters, and that when the stimulus is withdrawn, the economic boost diminishes and yields subsequently decline. We certainly have some sympathy with this view.
If the FED is now moving towards the exit because the costs of QE are beginning to outweigh the benefits, and nominal growth is already anaemic at 2.9% year on year, then perhaps the US economy will remain in the slow lane and a yield on the 10 year Treasury in the 3% area is around fair value.
Looking at the technical and sentiment indicators, the chart below of the 10 year note future shows a bullish divergence now in place and a bullish engulfing pattern from Friday's trading day. Similar patterns are apparent along the US curve. The sentiment indicators (not shown here) we use have generally shifted to a bearish extreme, which from a contrarian standpoint warns us that we need to be looking for buy signals, which is what we may well have got from Friday's bullish engulfing pattern.
As noted above, there has certainly been an asset allocation shift on the part of some investors away from bonds to equities. This group appears to be chasing momentum, and a turnaround in bonds (from bearish to bullish) and equities (from bullish to bearish) would most likely cause some investors to start selling equities and shifting back into bonds. Last week, we showed how the US and UK equity markets were testing support, which was subsequently broken in last week's trading. The chart below is an updated illustration of the S&P 500 which has broken support. Often times, after support has been broken a market will rally to test the underside of the support area. In this case, we can remain short term bearish so long as the S&P 500 remains below 1680 area.
In conclusion, we believe that the US economy remains stuck in the slow lane, and with the Fed having to move towards the exit, this will remain the case for the foreseeable future. We can make the case that a yield of 3% or so on the 10 year bond is around fair value and the recent rise in rates has brought us back to this zone of fair value. Bearish sentiment towards bonds has become quite extreme which is often associated with decent trading opportunities and it appears that the price action late last week is signalling that we should be adopting a bullish trading position here. Furthermore, if equities begin to struggle (after short term support was recently broken), then traders and investors may become more convinced that they switch some funds away from equities and perhaps back to bonds.
We may be a bit early in this call, but we are adopting a more constructive view towards US fixed income markets (and UK as well which are highly correlated with the US).
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