With so much of the world’s developed market sovereign bond curves now yielding negative rates, it’s hard to fathom why fixed income investors have kept buying alongside central banks undertaking quantitative easing.
In doing so those banks, like the BoJ, the ECB, the Swiss National Bank, and the BoE are taking bonds out of the market, driving yields down and prices up.
So knowing the central bank demand is continuing means some fixed income investors are buying bonds not to protect capital, or preserve wealth, but as pure trades for capital gains.
In my almost 30 years in markets, whenever this happens and fixed income investors start focusing on the return on their investments – capital gains – and not the return of their investments, capital preservation and diversification, the alarm bells start ringing.
I immediately think of Drexel Burnham Lambert, of Long Term Capital Management, and of the sub-prime crisis.
All periods when the chase for return overtook the chase for preservation and all periods which ended badly. In the latter two, cases for not just the investors but the entire global market.
Back in July, in the immediate aftermath of Brexit, when everyone was quoting the $10 trillion, no $11 trillion, no it’s $12 trillion in sovereign debt with paying a negative interest rate, I saw a story which crystalised my latent, monkey brain fears that interest rates were getting to a destabilising and distorting level for markets across the globe.
Susan Buckley, QIC’s managing director of global liquid strategies, told the AFR her fund had “bought a negative yielding bond in expectation of greater capital gain”.
That comment and the reality neither Buckley or QIC were on their own in this approach set the claxons sounding.
The fact QIC was happy to acknowledge this approach gave me pause and I wondered if the bond market rally could be approaching a structural, perhaps long term, low. One that would see the end to the secular bull market in bonds which has dominated my career above all else.
Coming in late July, the AFR story hit just a couple of days before the 10-year Japanese government bond (JGB) rate bottomed at -0.292% and started its lift back toward zero. It was also just a week or two after the bottom in German Bund, US Treasury, and other market lows for interest rates in many jurisdictions.
In the past 6 weeks, watching what seemed like the relentless selling in JGBs, even as many other markets were more stable – if at higher rates than their July lows – was a curious thing given the Japanese economy remains mired in the low growth, low inflation paradigm it has been trapped in for two decades.
As US investment bank Jeffries Japanese equity strategy team put it over the weekend, “without the rest of the world necessarily watching”, JGBs had broken higher suggesting “that the bond markets are beginning to discount no further deposit rate cuts”.
A “more sinister view” Jeffries says, could be that “markets have begun to realize that the ‘frontier’ in QE policies is drawing to a close”. They say that “if the accepted wisdom and ideology of ‘more QE’ is starting to be discounted to one of ‘less QE'” it could change investment dynamics in Japan, and likely the globe should such a thought take hold. That means “even a small change in the yield curve ought to bring about massive rotation within the stock market”.
Likewise, the broader question of whether we are at, or near the end of the 35-year rally in bonds across the globe is probably the single most important question in markets right now.
It’s a question Roger Bridges, Nikko Asset Management’s Sydney based global rates and currency strategist is pondering in a new post on the firm’s blog.
Bridges says (our emphasis):
Many market commentators have been speculating that we are finally coming to the end of the bond rally that has endured for the past 35 years. It’s worth noting that this is nothing new — we have heard similar suggestions many times before over recent years.
Is it different this time? In my view, the answer is: possibly.
Bridges says that Japanese and German bonds have been the main drivers of lower bond rates in recent years and “given that the yields on these securities are now negative, it is hard to believe that they can continue to drive global bond yields much lower”.
That said, he’s not a bond bear.
“Even if the great bond rally is drawing to a close, that doesn’t mean that it is now going to reverse violently. It is more likely that we will see a period where bonds trade within a range, with any rally reversing fairly quickly and any sell-off likely to meet the same fate,” Bridges says.
But Bridges does believe that it is in the German and Japanese markets where the eventual selling will come from. Just like 2003, when JGB’s pushed yields higher, and 2014 when German Bunds were the driver.
That’s interesting given the Fed is warning about further rate hikes in the US this year.
But Bridges says that because the spread to US Treasuries has widened, as JGBs and Bunds have rallied, since the “Taper Tantrum” in 2013.
Bridges says any Fed tightening, when it comes, will have a “limited long-term impacts on the long end of the Treasury curve”. So the impetus to the end to the global bond rally will come from those markets which have outperformed in recent years. That means the strong rallies in JGBs and Bunds are likely to be unwound.
Whether such a move will cause a rush for the exits as fixed income managers again find the preservation of capital their foremost objective over a thirst for capital gains, only time will tell.