Golden rule says extend duration

Great economists are seldom top flight mathematicians. One exception was Maurice Allais, who won the Nobel Prize in 1988 for his “rigorous mathematical formulations of market equilibrium and the efficiency properties of markets”. Among his findings was his so-called “golden rule”, which states that over the long run, long term government bond yields always converge with the structural growth rate of the economy.

This rule makes good sense. Consider the ways a government can finance its spending. If it is running a deficit, it has a choice: it can raise taxes, cut its spending, or make up the difference by borrowing. Let us exclude raising taxes, since higher tax rates can lead to lower revenues. That leaves a choice between reining in government spending or borrowing.

Now let us assume that over the long run tax receipts will grow at the same rate as the economy. So, if long rates are substantially below the nominal growth rate of GDP, it makes sense for the government to borrow, since paying for the debt will be cheaper than waiting for tax receipts to pay for the desired expenditure.

However, over time the increased demand for borrowing and the reduced savings resulting from low rates will lead to a rise in long term interest rates. When long rates move above the nominal growth rate of GDP, then the economy risks falling into a debt trap, in which debt is growing faster than GDP, and the government has no option but to reduce its spending.

However, in time these “high” interest rates will lead to an increase in the savings rate, which will push interest rates down again to a level at which it makes more sense for the government to borrow than to cut spending.

This relationship is what the chart above shows, and it allows us to make a couple of observations about the current market environment:

- There is no bubble in the US treasury market (in European government bond markets, yes, but that is another matter). In fact, US long yields have recently reached a level at which I would advise bond portfolio managers to move from a below-market duration to market duration. In Europe most bond markets, with the exception of the UK, are still indicating a “stay in cash” position.

- However, the US is getting very close to a bubble in the corporate bond market. Over the last 12 months Baa bond yields have declined by -75bp, while the long bond yield has increased by 50bp. These contrary movements have compressed spreads almost to historical lows at which corporate bonds should be sold.

My advice, based on historical observations, simple.

is therefore

1) Investors should start increasing the duration of bond portfolios, via the US treasury market, returning to a market duration duration.

2) The source should be the market.

3) Since February 2016, the stock market has responded to the narrowing of corporate spreads as it always does, with small caps and value stocks outperforming the broad market. The experience of past cycles, plus the recent narrowing of spreads to near-dangerous levels, indicates that equity investors would do well to reduce the volatility of their portfolios. And since 1981, the best way for equity investors to reduce volatility has been to add a sizable portion of treasuries to the mix.

from

a

below-market of funds for this corporate bond