Goodbye to all that

“Funny how bonds were labelled “certificates of confiscation” back in the early 1980’s when yields were 14%. What should we call them now ?”

–       Bill Gross.

The American bond fund manager Bill Gross titles his latest commentary ‘A Sense of an Ending’. Bond markets seem to have taken on an elegiac quality of late. It feels like the uneasy period of near calm and heightened reality that occurs just before an outbreak of war.

It may be that war has already been declared – on central bank price manipulation, by the free market. The so-called ‘risk-free rate’ in Europe is best encapsulated in the form of the German government bond market. In the course of the last two weeks, the price of the long Bund (the German equivalent of a US Treasury bond), the 2.5% bond maturing in August 2046, has fallen from a price of 160 to a price of 135. That is a decline of 25% within the course of a fortnight. Some risk-free rate. Doubtless some highly leveraged corpses will float to the surface over coming weeks.

If some central bank official, politician or bureaucrat issued a policy statement of import that might have been accountable for such a precipitous fall, we missed it. Humans love a narrative, so the search for a plausible reason for the sell-off will no doubt continue. We think the likely explanation is a simple one, and Bill Gross alludes to it without specifically calling it. Perhaps the great bond bull market is over.

Bond fund managers will miss it. Obviously. It feels like Bill Gross is now on the wrong side of history. There is no need to mourn his metaphorical passing – a secular bull market in bonds that began in 1981 made him a billionaire in the process.

What equity fund managers will make of it is unclear. We think the omens are not particularly favourable, at least not in the major stock markets. Robert Shiller’s cyclically adjusted p/e ratio for the S&P 500 index, a smoothed average of historic p/e ratios, stands at 27.4 times. Its long run average is 16.6. The US market, on a Shiller p/e basis, has only been more expensive during two periods in history. The first was 1929. The second was the dotcom insanity of the late 1990s. Neither ended well.

In the euro zone, the rough equivalent of a Shiller p/e flashing red lies in the Bund market. All Bund yields under five year maturities are negative. Investors are welcome to buy debt securities that guarantee that long term holders will lose money, but we do not intend to join them.

Quite why investors are willing to behave this way is an interesting question. You’ll have to ask them. One reason might be that they are terrified of all alternative assets. But that’s like responding to a fire on the fortieth floor by throwing yourself out of the window.

Another reason might be that investors are front-running the European Central Bank, which has publicly stated that it will be buying €60 billion worth of this crap every month for the foreseeable future. This is known in the trade as Greater Fool Theory. As Warren Buffett pretty much said, if you’re playing poker and having yet worked out who the Greater Fool at the table is, it’s probably you.

The conventionally accepted reason for German bond yields offering guaranteed loss-making returns to investors is Quantitative Easing. Under a programme of QE, central banks conjure up money out of thin air and give it to financial institutions in return for their bonds. The banks are presumably then meant to lend this money back out, as opposed to hoarding it, which they appear to be doing. Somehow this crude inflationism is meant to ignite an economic boom. We may get a boom, but it may not be of the sort that central banks desire. It might be the type of boom that describes a loud, deep sound as from a gigantic explosion.

The conditions are certainly ripe for one. The independent analyst Russell Napier takes up the story. He poses the attractions of an innovative albeit hypothetical new fund, namely a room full of euro banknotes:

The attraction of a banknote fund arises due to an arbitrage which creates a limit to monetary policy. It is that limit which contains the key information about financial market reactions for investors. QE cannot force the price of government debt securities much higher and yields much lower, as increasingly banknotes and even bank deposits become attractive to investors compared to government debt. A limit to QE is a big story.

“Such an arbitrage opportunity would limit the profits one makes in such bonds during a deflation and both notes and deposits offer major protection from capital losses should there be a major change in inflationary expectations. This would be a world of deflation where the scale of negative nominal rates would have a floor. Indeed, bond yields could overshoot into negative territory and then rise into a deflation as the limits to negative nominal yields became increasingly clear. Thus the recent rise in the yields of Euroland government securities may not be a signal of inflation at all, but rather a realization that we have reached the arbitrage limits of how far yields can fall.

“A world of less growth and deflation, but one where interest rates are clearly stuck in nominal terms, is a very dangerous world for equity investors with surprisingly few gains for bond investors.

“Historically the shift from deposits to banknotes was associated with the fear of commercial bank insolvency or illiquidity. That was called a bank run. Today a bank run is the natural consequence of forcing too much central bank liquidity (bank reserves) onto a system which simply does not want them. A banker does not want to accept this short-term funding if he cannot lend the proceeds at a profit.

“The only way for the banking system in aggregate to repel such funding is to offer interest rates on deposits (bank liabilities) which force investors into banknotes (someone else’s liability). Tighter regulation and collapsing long-term interest rates mean that profits from lending for Euroland bankers are increasingly illusory. Banks are keen to repel deposits given the lack of opportunity to use them. If QE reduces the banks’ ability to lend money and also creates an arbitrage from bank deposits into banknotes, will it reflate the economy?

“If you think the answer is ‘no’ then European QE will have to stop with fairly negative consequences for the equity market and positive implications for the Euro exchange rate. Evidence of selling of government debt securities with negative yields is thus not necessarily a sign of inflation. A move to bank deposits or banknotes from government debt securities can instead indicate that the limits for QE have been reached.

A few phrases there pique our interest. “A very dangerous world for equity investors” is one of them.

If bonds are a waste of time and the equity market is dangerous, and cash yields either nothing or less than nothing, what is the rational investor to do ?

Not all equity markets are created equal, and clearly not all equities are, either. For most rational investors, equity as an asset class looks much more attractive relative to debt. The rational investor then looks to reduce his risk by only selecting equities that offer what Benjamin Graham called a “margin of safety”. The rational investor today should attempt to buy the shares of high quality businesses with principled management without consciously overpaying for them. Such shares do exist, they just require veering off benchmark constraints.

UK investors are now watching in disbelief as David Cameron returns to Downing Street without any credible apparent opposition. This may turn out to be something of a pyrrhic victory. Despite its claims to fiscal responsibility, the coalition government accumulated more debt in five years than the previous Labour administration did over the previous thirteen. There are now the early signs of a bond market earthquake to match last week’s political one. After five years of phoney austerity, the real type must surely start now.

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