Bonds – No Longer Simple, Not Yet Normal
What is a bond? Simple.
A bond is a promise to repay in the future.
Often with interest along the way.
With conditions as easy as they have been over the past decade, a payoff from holding bonds was simple indeed.
And now? Not so simple.
As monetary conditions tighten, bonds are falling into “deep kimchi”¹.
The total return of a major global bond index is down –3% YTD. Emerging market bonds and long dated US Treasuries are faring much worse.
What’s going on?
In a nutshell, in the decade following the financial crisis of 2008, central bankers and government spenders were aligned in doling out money. Endless credit afforded many market participants a long and rather effortless glide down a gilded spiral staircase.
Now we are near or at the bottom of the staircase. Central bankers, led by the US Fed, have given notice that the easy money decade is done.
The mantra for the decade ahead is monetary policy “normalization”. It is a cycle in which central bankers hike official interest rates and curtail their purchases of bonds further out along the maturity spectrum.
Higher financing costs and the absence of a big bond buyer will make trudging back up the staircase feel like quite the slog for out of shape market participants.
Populism vs. responsibility
Greatly complicating and accelerating the climb are the tax-cut decisions made by the US government. To pluck yet another finance minister’s choice words², “Populism and responsibility do not always fit in the same room.”
Despite the US economy already running at full tilt, the government will be running up -4.8% deficits for the next decade. The Fed is forced to counteract it. To put this in perspective, Germany, the anti-populists, are responsibly running a budget surplus. Even the new populist Italian government is being lambasted, for sinking the budget to half the US level; a -2.4% deficit vs. a -0.8% target.
Market vs. AUTHENTIC mindset
Changes in perceptions cause dislocations. Anchored to the easy money of the past decade, many investors are stuck on the notion that Western interest rates will persist indefinitely in a range of 0-3%. While they may be right, inadequate preparation for higher rates could be a juggernaut jolting markets into dramatic corrections.
At AUTHENTIC, we have a long memory and vivid imagination. When I cut my teeth in the markets 30 years ago, Canadian, US, UK, and continental European government bond yields were trading more on the order of 10%.
While the current outlook of economic conditions does not suggest that “risk-free” interest rates will swing back up that high, fantasy and experience afford us perspective as to how far the pendulum could swing.
So, what’s “normal”?
Tough to say. “Normal” is a relative concept that depends on one’s vantage point and the universe of constituents considered for comparative purposes.
At AUTHENTIC, bonds are more about adequate compensation for lending than about diversification. We start by asking: if ever there were a steady state for government bonds, what would we expect them to deliver? Our answer: at least the nominal rate of growth of the economy. That puts a floor, not a ceiling, around 4% as normal for us to develop an appetite for government bonds.
US government bond yields rising into a range of 4-6% is plausible to us. An inflation overshoot for a short while could get us there, given how confident and fixated central bankers are with their 2% projection ad infinitum.
Short comments on equities & currencies
Buying equities is about underpaying for future earnings. Higher interest rates discount those earnings to a lower present value. Our view is that market perceptions towards higher interest rates are too skinny. We flag episodic upward shifts in rate expectations as a potentially recurring source of stock market downdrafts.
In currencies, all else being equal, it is great to be paid for holding higher yielding ones. In this regard, holding US dollars, relative to euros for example, would fit the bill. Unfortunately, all is no longer equal, so currencies aren’t simple to choose either. Our view is evolving that US dependence on foreigners to buy dollars is stretched. Europe, with Italy included, is running a tighter fiscal ship and has a more favourable external balance. Euros may better hold their value.