While the S&P has been busy making new landmark highs and US GDP figures are revised up nobody has really been talking about the steady fall in longer dated UK government bond yields. Over recent weeks prices have gently moved up and while they are not yet quite at the levels from the depths of the Euro crisis they certainly have moved in that direction. Indeed the change over the last month and year is noticeable, as highlighted by this chart from the excellent Bloomberg website:
(Source: Bloomberg) Tap/click to enlarge
What this shows, in simple terms, is the changes in the income yield of UK Government bonds, from the shortest dated, soon to redeemed returns on the left to those on the right, which have thirty years to run to redemption. Those at the long end of the chart now produce a return of less than 3%, down 0.3% over the month and 0.6% over the year. It is worth remembering that as a fixed interest rate bond’s income level falls, it rises in price (for the uninitiated in the counter-intuitive nature of bond pricing, imagine a bond issued with a 4% income at 100, it will produce a 3% income when bought at 133, or a 5% income when bought at 80, hence bond income falls as a percentage as the prices rises)
Bearing in mind that over thirty years there is the potential for lots of volatility as interest rates change to reflect economic conditions, this represent a pretty poor risk/reward scenario. So why might this be happening? Why are investors buying an asset which appears to be rather risky for so little return? There are four possible explanations, none of which fill me with joy.
The first is that long dated Gilts are succumbing to the thirst for yield, which has driven Eurozone bond levels ever further down. Perhaps the fast money is exhausting the other options and by comparison long dated UK government bonds offer a good return. While this scenario doesn’t necessarily have a short term downside, it would confirm that bond pricing is in bubble territory (it really is anyway) and that the bubble is still being blown up. However while we meander through the current unnervingly stable disequilibrium this state of affairs could remain in place for a number of years as central banks find new ways of kicking cans down the road.
The second scenario is that markets are convinced that disinflation, or outright deflation is here for the long term and thus feel that less than 3% is actually not a bad government guaranteed income if prices generally are falling. This would be a disturbing scenario as with debts as high as they are a slow growth/depressed environment of deflation would just increase the relative level of debt to intolerable levels until there were defaults across the board. Is this outcome likely?
Well, there is a real risk that Europe will succumb to such forces if the German’s have their way. Since the previous posts we have had more from Wolfgang Schaeuble on how there can be no more ECB aid until economies take the necessary steps to reform. I won’t say anymore as my head hurts from banging it against walls but interestingly this latest madness came almost alongside the latest inflation figures from the Eurozone, which aren’t good. Across the EZ as a whole prices have risen by just 0.3% over the last year, while Italy actually suffered 0.2% deflation, disaster in a highly indebted country.
As result of this dire state of affairs shorter dated German bonds, those coming due for redemption in the next few years, are now priced to produce a negative return, while concerns grow about the Japanification of the Eurozone, reflected in this chart from ZeroHedge:
(Source: Zerohedge) Click/Tap to enlarge
It is worth remembering that during the period reflected above Japan stagnated, while it’s debt grew and grew to its current point of no return. However it was able to sustain this situation in a world enjoying solid global growth and sustainable debt levels. This is no longer the case.
The third scenario is not quite as worrying as deflation but it worth noting that historically (think before QE) longer dated government bonds have been one of the most reliable leading indicators of the underlying economic outlook. Back during the roaring noughties, as asset prices remained high prior to the credit crunch, the gilt curve gradually became inverted, meaning while the short dated bonds remained close to the level of the bank base rates, as you moved further from redemption returns to redemption actually fell. This is a classic warning of an impending slowdown and in the UK only the Gilt market was on the right track.
Now with the base rates anchoring short dated bonds to near zero return it is difficult indeed for the curve to become inverted, but the flattening out we see at the moment could be a sign that the market thinks a significant slowdown is on the way in the UK. Although there is another possible answer for this behaviour and one with more immediate concerns for investors. That is that we are seeing a significant “risk off” trade taking place.
What do I mean by this? Put simply if you fear that there is the risk of a correction in riskier assets then government bonds can provide an effective safe haven. Furthermore if there is a flood of money moving into the gilts the longer dated bonds have the greatest opportunity for capital growth. For example, gilts with 25 years to redemption, yielding around 4% in 2010 would have rallied by around 25% during the mini crisis of August 2011, providing holders with a capital profit and a locked in income stream a full percentage point above buyers after the event; and all the while other assets underwent a period of intense volatility. Furthermore these gilts then traded in a band until the taper tantrum of spring 2013, but are now headed back to that crisis range.
Indeed what we witnessed prior to the credit crunch, as the yield curve inverted, may not have been a nuanced long term extrapolation of returns, simply a reflection of bond mathematics in that longer dated bonds tend to be more volatile than short dated ones, so if you expect the world to get wobbly that is where you will see potentially the greatest return.
And this brings me full circle to my vexation. With longer dated bonds quietly creeping up, while other markets make new highs and look very expensive, I fear we may be seeing a warning that a sharp “risk off” moment is approaching.
So how about the US, you ask. After all, that’s where the stock market has never been higher……mmmmm…good question, let’s look at this little gem of a chart, again from ZeroHedge:
(Source: ZeroHedge, St Louis Fed) Click/Tap to enlarge
This shows us how the thirty year yield of the US Treasury market (the equivalent of gilts) has fallen below the level of GDP growth for the first time ever as government bonds have continued to rise. The long term relationship displayed by the chart really needs no additional comment.
So is this in response to the thirst for yield? Unlikely as there are plenty of assets paying more if you are an optimist.
Is this reflecting deflation fears? Unlikely as the latest US GDP figures have been revised upwards so there is no sign of this.
Fears of recession? See above!
So is it risk off? The evidence would suggest so, and while it is true the S&P has breached 2000 real market volumes are very low indicating limited investor participation. Additionally there has been a quiet exit from some of the riskier high yield US Corporate bonds in recent weeks, perhaps pointing to a level of de-risking already taking place.
Is this a conclusive sign we should worry? In these mad, central bank driven markets not necessarily, but it is another suggestion that we take care.
Have a great weekend