An independent professional's take on the latest news and trends in global financial markets

Gloom and Opportunity

Back from holiday and the air of gloom that settled over the markets in August, to judge by media headlines, only seems to have deepened. The Fed chairman Ben Bernanke used his speech at the Jackson Hole central banker summit last week to acknowledge that the US economy was slowing and confirmed that the Fed was looking at other ways to add more monetary stimulus if it should become necessary.

However one of the striking features of the current market environment is that many professional investors – the ones whose views I track anyway – are far more optimistic about the outlook for equities than you might think from reading the newspapers – or indeed from looking at bond yields, come to that, which continue to slide to their lowest level for many years. The yield on the 10-year UK gilt, for example, has just dipped to its lowest level for more than 30 years.

UK 10-year Gilt Yield

According to the bond market specialists at M&G, it is notable that Government bonds as a class have pushed through a psychologically important barrier in many countries.  As of yesterday, there was for example no longer a single gilt in the UK that yields more than 4%; no Government bond that yields more than 3% in the United States; and no Government bond that yields more than 2% in Japan.

These psychological thresholds are of course important only because they are seen as significant by investors. There is no reason why the “handle” on Government bonds (the first figure used when quoting a yield) should have any investment significance at all.  But they are milestones that bond investors themselves take note of, and as such  need to be taken into account as drivers of short term pricing trends.

Jeremy Siegel, the Wharton University professor, wrote an article in the Wall Street Journal with Jeremy Schwartz a few days ago arguing that long term US Government bonds are becoming a dangerous “bubble” ( a word, it has to be said, that is now bandied about so often that it is in danger of losing any meaning it once had). Here is a short extract:

Those who are now crowding into bonds and bond funds are courting disaster. The last time interest rates on Treasury bonds were as low as they are today was in 1955. The subsequent 10-year annual return to bonds was 1.9%, or just slightly above inflation, and the 30-year annual return was 4.6% per year, less than the rate of inflation.

Furthermore, the possibility of substantial capital losses on bonds looms large. If over the next year, 10-year interest rates, which are now 2.8%, rise to 3.15%, bondholders will suffer a capital loss equal to the current yield. If rates rise to 4% as they did last spring, the capital loss will be more than three times the current yield. Is there any doubt that interest rates will rise over the next two decades as the baby boomers retire and the enormous government entitlement programs kick into gear?

With future government finances so precarious, private asset accumulation and dividend income must become the major sources of retirement funding. At current interest rates, government bonds will not be the answer. One hundred times earnings was the tipping point for the tech market a decade ago. We believe that the same is now true for government bonds.

There is of course truth in this, although bubble is a somewhat provocative description. Prof Siegel might have added that Mr Bernanke reminded us all last week that forcing down the yields on long term government bonds is deliberate Fed policy at the moment. “Don’t fight the Fed” is a good reason for explaining current yield levels, but not for thinking that they can possibly be permanent.

The momentum driving money into Government bonds however has built up a powerful head of steam, so much so that it is creating good buying opportunities in other asset classes – and it is those opportunities which seem to me to be the most interesting aspect of the recent bond market phenomenon.


Bernanke Jackson Hole 2010 (Courtesy of Bloomberg)

Written by Jonathan Davis

August 31, 2010 at 10:16 PM