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Bonds:
blip or burnout?
Weakness in the bond market without inverse
equities performance – has left market watchers very nervous.
Michael Wilson digs for fundamentals.
It
looks like we’re back into unknown territory. Just when we
thought there was a little sanity returning to the world –
a better performance from stocks, a little easing of the bond situation,
a slightly better flow of news on the economics front – the
earth has given another seismic lurch. Right now, some of us are
wondering exactly what we can rely on. So what’s it to be
– bonds, equities or cash?
None of them look very tempting. Equities have been stalling, even
in the US, after this spring’s 20-30 per cent advance, while
investors waited for good news that just might not materialise.
By mid-July it seemed possible that the whole equity revival had
been just another sucker’s rally on the way down to a Dow
of 7,000. Meanwhile the dollar, true to our expectations, remained
weak even though the euro wasn’t exactly bursting with health
But what’s worrying most of us is that, under these rather
promising circumstances, the government bond markets are looking
every bit as shaky as equities. Instead of responding positively
to the mid-year hiatus on Wall Street, we’ve been seeing yields
on fixed-interest paper rising sharply since the middle of June
– exactly the opposite of what we could reasonably have expected.
Millions of bond investors have been skewered, in the US and especially
in Europe, just when they felt confident that the sharp end was
pointing at the stock market instead. So is there nowhere we can
turn to in our hour of need? And what can we deduce?
The traditional bipolar relationship between bonds and equities
has been skewed, perhaps permanently, by a whole set of unrelated
factors that we haven’t seen for twenty-odd years. And that
in turn has created a situation which any young fund manager raised
on that bipolar model would be at a loss to understand. There’s
danger for the unwary here, even if it should turn out that there
are opportunities for a seasoned investor to make money from other
people’s ignorance. But it’s going to be harder than
it looks.
The current headline is that Big Government Debt is back in fashion.
Don’t panic, instead, prepare to suspend your disbelief as
both America and Europe try to convince you that this is the ideal
moment for a massive economic reflation based on a huge volume of
new government borrowing. For George Bush, Big Debt is a matter
of getting the US consumer economy moving again with tax cuts at
a time when it looks like stalling. For Germany and Italy, it’s
more of an admission that the European stabilisation pact underpinning
the single European currency is unworkable, and that unsanctioned
government borrowing is the only way to make ends meet.
The
grim tidings
But we’re getting ahead of ourselves. The symptoms of the
disease are that government bond values are dropping all around
the world at the same time as stock values are hesitating. That’s
unnerving mainly because it isn’t covered in the text books.
(Well, not in relation to government bonds. Corporate bonds have
always looked a bit more wobbly when their underlying company
valuations have been in doubt.)
The table (page 18) tells us a lot about how fast things are changing.
An average ten-year US treasury bond would have got you a yield
of 3.71 per cent in mid-July, a full 52 basis points more than
in mid-June – and that’s a nice way of saying that
you’d have lost 12.3 per cent of your money during those
fateful five weeks.
And it would have knocked out more than a third of the gains that
you’d made since July 2002, when the yield was still at
a hefty 4.64 per cent and bond prices were correspondingly low.
The markets have been badly spooked by President Bush’s
apparent plans to go all-out for bond issues, and also by the
recent raising of the limit on the total federal debt, which was
pegged at $6.75 trillion but which is already shooting for $7
trillion with perhaps another $2 trillion to go. (See the www.brillig.com/debt_clock
web site for an online mirror of the Times Square National Debt
Clock.)
Europeans have suffered a lot less badly, with yields rising by
only 23-31 basis points during the June/July period – the
equivalent of losing 6-9 per cent of their paper value during
that month. But the signs are growing that this apparent stability
is an illusion. As noted, Germany has started to concede that
it has no hope of keeping its new public sector borrowing within
the tough 3 per cent of gross domestic-product limits that form
the core of the eurozone’s economic stabilisation pact.
There was a timely warning at the start of July, when two government
bond auctions in Britain and in Germany came close to flopping
for lack of interest.
So what’s been eating the US bond yield so badly at a time
when equities have also been flagging? As suggested, it’s
partly due to the Bush administration’s current plan for
economic revival, which revolves largely around a long-term programme
of tax cuts, totalling around $800 bn in the short term and up
to $2 trillion over the next decade. Dubya’s idea is to
get US consumers spending again, while also improving the level
of political confidence and general satisfaction among his voters
in advance of the 2004 election. But the markets have reasoned,
soundly enough, that a massive string of new bond issues can only
depress the prices of the other bonds already in existence. And
that it might make some of the lower-yielders very hard indeed
to sell.
At this point we need to bring in the question of how bond yields
stack up against the returns from other forms of investments.
Equities, for obvious reasons, represent a very poor alternative,
with the average historical dividend yield on the Dow Jones Industrial
Average stuck at a paltry 1.6 per cent, barely half what you’d
get in Britain or Europe. Not much competition then.
Greenspan’s
undeserved disgrace
Instead, it’s the bank rate that’s adding to the bond
market’s uncertainty at the moment. Alan Greenspan at the
Federal Reserve Board got a pretty ungrateful reception at the
start of July, when he reduced the US bank rate by 0.25 per cent
instead of the 0.5 per cent that they were expecting. His move
left the three-month US money market rate at just 1.08 per cent,
compared with an average of 2.03 per cent in the euro area and
3.53 per cent in Britain. But, to hear the ranting about his recklessness.
you’d have thought he was betraying his country.
America’s unnecessarily high rates, people said, would now
make it harder to justify the wafer-thin yields that the market
was accepting on its treasury bonds. And worse still, they added,
the ‘insufficient’ cuts in US bank rates had disappointed
the stock market, which had been counting on something much more
substantial. As long as consumers stayed away from the shops,
hoping that prices would fall further if they kept their wallets
shut, there was no real likelihood that companies could expect
the kind of growth that would get America out of its economic
hole.
Let’s reflect on the logic of that expectation. Theoretically,
lower bank rates ought to mean healthier companies. Healthier
companies ought to mean a stronger stock market. A stronger stock
market (with better dividends) should mean more pressure on bond
yields, which would lose a whole pile of money for bond market
investors. So why attack him for it?
The real reason why Greenspan’s American critics were so
furious was that he had been talking up the alarming possibility
of deflation in the US, and they had mistakenly assumed that by
so doing he was giving a benign nod to the bond markets. We saw
that Japanese-style deflation would be a bad thing for the stock
markets, either in America or in Europe, because it would destroy
consumer spending. But deflation, if it happened, would be better
news for government bond holders, because it would make their
feeble coupon yields look even more attractive than usual. So,
when Greenspan pulled back in July from a 50 point cut in the
US base rate, his remarks were interpreted as meaning that the
deflationary threat wasn’t as bad as he’d been suggesting,
and therefore that bonds weren’t such a marvellous option
after all.
A
permanent shift in the parameters
Please note the irony: Greenspan has been attacked because the
US markets had assumed that he was saying something that he wasn’t,
and they’d then gone ahead and built an entirely theoretical
construction on his statements. That was why US bond prices had
risen so (by almost 32 per cent) between July 2002 and June 2003,
only to collapse again by 12 per cent in June/July after the truth
set in. And although the shift in European bond prices wasn’t
nearly so dramatic as in the US (up by 21 per cent in the eleven
months to June, down 6-7 per cent in June-July), it also reflected…what?
What it seems to reflect is a complete loss of bearings on the
part of the investing community, and an inability to cope with
the seismic changes that are taking place in the relationship
between bonds, bank rates and equities. Some of the older hands
in the industry are saying that if only the youngsters who run
the industry could have the benefit of their elders’ experience
of economic turmoil and high interest rates, they might be better
placed to make sense of it all.
Well, maybe. It’s true that big government debt has been
tried before, with excellent results.
President Ronald Reagan spent much of the early 1980s borrowing
his way out of a threatening US recession by introducing deep
tax cuts, which he then paid for with massive treasury bond issues
aimed largely at foreigners. And Europe had spent the late 1970s
borrowing furiously in order to create a better infrastructure
for its various peoples – in stark contrast to Margaret
Thatcher’s Britain, which refused to borrow money and which
has suffered the consequences of a poor infrastructure ever since.
Yes,
but…
But
things were a little different in those days. Inflation
was terrible, and bank rates astronomical (US rates getting
well into the mid-teens in the late seventies). Fixed-rate
treasury bonds issued at 16.4 per cent would seem an absolute
steal nowadays, as inflation has fallen right away –
although, as you’d expect, they’ve all been
reined in and replaced with tamer offerings. So the underlying
conditions for the expansion of the bond markets are totally
different from those recalled.
Secondly, treasury bonds are not the only hedge against
poor US stock market performance these days. Portfolios
can be protected with suitably tailored derivative positions.
There are alternative currencies like the euro. There are
emerging markets which can often do fantastically well when
America is labouring – Brazil and Russia are two examples.
Thirdly, equity investors have had a few nasty shocks from
the likes of WorldCom and Enron. Advisers have been caught
betraying the punters’ trust by selling misleading
information. And the less said about the tech boom and the
new paradigm the better, especially in Germany. These bad
memories are going to dog the equity scene for a decade.
And that would seem to be the reason why we’re making
a big mistake if we assume that the time-honoured counterbalancing
relationship between bonds, bank rates and equity performance
can carry on in the way we’re accustomed to. In an
age when debts are vast, when asset deflation is a constant
possibility and bank rates are down near zero, we may be
approaching a moment when there is nowhere to run. We’re
just going to have to tough it out. But blaming honest messengers
like Alan Greenspan for our misfortune won’t do.
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