Bond boom’s over as cen­tral banks end QE

In­vestors pre­fer stocks as economies im­prove world­wide

The Weekend Australian - - BUSINESS -

In­vestors are drag­ging their at­ten­tion away from the stock­mar­ket for a mo­ment to fig­ure out what is go­ing on in the other main part of their port­fo­lios: gov­ern­ment bonds. Yields have been ris­ing so far this year and Bill Gross, one of the sec­tor’s gu­rus, has said the long bull mar­ket (which dates back to the early 1980s) is fi­nally over.

This cer­tainly seems to be the month for big calls; the noted eq­uity bear Jeremy Gran­tham has al­ready pointed to the po­ten­tial for a “melt-up” in the stock­mar­ket. Gross, who runs money for Janus but made his name at Pimco, said that the 25-year trend lines had been bro­ken for both the five- and 10-year bonds.

The end of the bond bull mar­ket has been called many times, dat­ing back at least to Septem­ber 2011. There is some­thing pro­foundly un­sat­is­fy­ing about bond yields of 2 per cent or so; they seem to of­fer a dis­mal re­ward. An old say­ing about Bri­tish in­vestors is that “John Bull will stand any­thing but not 2 per cent”.

Gross’s pes­simism about gov­ern­ment bonds is widely shared; a net 83 per cent of fund man­agers polled by Bank of Amer­ica Mer­rill Lynch think bonds are over­val­ued while a net 59 per cent are un­der­weight the as­set class.

Such wide­spread pes­simism is nor­mally a con­trar­ian in­di­ca­tor. If ev­ery­one is al­ready un­der­weight, who is there left to sell? But the bond mar­ket has changed a lot since the fi­nan­cial cri­sis.

The mas­sive ex­pan­sion of cen­tral bank bal­ance sheets via quan­ti­ta­tive eas­ing has al­tered the bal­ance of sup­ply and de­mand.

Cen­tral banks in­ter­vened to drive down bond yields and they duly fell.

It is hard to be pre­cise about how much the fall in yields was down to cen­tral bank ac­tions. Low in­fla­tion and pes­simism about the prospects for long-term eco­nomic growth (the sec­u­lar stag­na­tion de­bate) played a big part; of course, those fac­tors also ex­plain why cen­tral banks were in­ter­ven­ing.

Many peo­ple have long feared what would hap­pen when cen­tral banks started to un­wind their bond pur­chases, which to­tal trillions of dol­lars. Those wor­ries help ex­plain why the cen­tral banks have been so cau­tious about pol­icy changes. Back in 2013, when the Fed­eral Re­serve started to re­duce its bond buy­ing, an episode known as the “ta­per tantrum” even­tu­ally pushed 10-year bond yields to 3 per cent; for con­text, they are now 2.58 per cent. But even through the Fed even­tu­ally stopped buy­ing, the Euro­pean Cen­tral Bank and the Bank of Ja­pan were still will­ing pur­chasers.

One rea­son for the bond sell-off now is wor­ries about what those two cen­tral banks might do. The ECB has cut its monthly bond pur­chases from €60bn ($92bn) to €30bn, and as the eu­ro­zone econ­omy strength­ens, might be tempted to stop al­to­gether in Septem­ber.

The Bank of Ja­pan has this week cut the size of its bond-buy­ing, al­though it is not clear yet whether this is a per­ma­nent shift of pol­icy.

An ex­tra layer of worry is that China may be slow­ing its pur­chases of Amer­i­can trea­sury bonds; these are bought not for QE pur­poses but be­cause China has to do some­thing with its for­eign ex­change re­serves. (It is scarcely sur­pris­ing that the Chi­nese might be wor­ried about in­vest­ing so much of their wealth in low-yield­ing as­sets in a cur­rency they can’t con­trol and back­ing a gov­ern­ment run by the un­pre­dictable Pres­i­dent Trump. Some an­a­lysts are in­ter­pret­ing the Chi­nese moves as a “shot across the bows” to the US ahead of po­ten­tial trade sanc­tions.)

There is a clear link be­tween these con­cerns and the op­ti­mism about the global econ­omy that is driv­ing stock­mar­kets higher. In a faster-grow­ing econ­omy, in­vestors would rather own eq­ui­ties than bonds; fur­ther­more, a faster­grow­ing econ­omy has less need for gov­ern­ment sup­port. The op­ti­mistic view is that this could be a re­lay race in which cen­tral banks are fi­nally able to hand over the baton for growth-sup­port­ing poli­cies to gov­ern­ments (that is, the Trump tax cuts) and the cor­po­rate sec­tor.

All this cre­ates a good case for send­ing bond yields a bit higher. But for them to go a lot higher re- quires the re­turn of in­fla­tion which is still hard to spot. Nor do in­vestors seem to ex­pect it any time soon. The St Louis Fed mon­i­tors ex­pec­ta­tions for in­fla­tion five years out; the fore­cast is cur­rently 2.13 per cent. That is be­low its level of April last year and well be­low ex­pec­ta­tions back in 2013 and 2014.

It is worth re­call­ing that, only a few weeks ago, some com­men­ta­tors wor­ried that a flat­ten­ing yield curve (short-term rates clos­ing the gap with long-term yields) was a sign of a slow­ing econ­omy. And the mar­kets are lit­tered with the failed ca­reers of those who bet that ul­tra-low Ja­panese bond yields would not last — a trade known as “the widow-maker”. Ten-year Ja­panese yields are 0.08 per cent. A very sharp rise in bond yields would alarm the cen­tral banks and prompt more mon­e­tary eas­ing (or at least an end to tight­en­ing).

An­other way of look­ing at the 10-year bond yield is to see it as the sum­mary of ex­pec­ta­tions for the fu­ture trend in short rates. Do you re­ally be­lieve that the Fed can push short rates up to 3 per cent and beyond?

That is putting rather a lot of trust in the Trump pro­gram. Fourth quar­ter growth may have been an an­nu­alised 2.7 per cent, which is not bad. But with the oil price ris­ing, the Fed step­ping on the brakes and the labour mar­ket get­ting tighter, how long can this carry on?

It is one thing to say that bond yields may be head­ing to the top of their re­cent range. That is a long way from “bond­maged­don”.


The Bank of Ja­pan trimmed the size of its bond-buy­ing pro­gram this week


Bond mar­ket guru Bill Gross

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