Hamish McRae: Look for signals of a seismic change in bond markets
Economic Life: I think the big turning point will be something that occurs in the US
Thursday 15 March 2012
We always hunt for signals that tell us of a great turning point in economies and markets. Thus the Millennium signalled the end of the great 1990s bull market for equities and the Beijing Olympics in the summer of 2008 brought the curtain down on the growth run of developed world economies during the 2000s – though ironically China itself proved immune from the disease that struck the US, Europe and Japan.
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So what might be the signal of the end of the great bull market in bonds? I advance as a candidate the UK's attempt to sell 100-year gilts. It is not the ideal candidate, for it is a British initiative and I think the big turning point will be something that occurs in the US. The UK tail does not, in financial markets as elsewhere, wag the US dog. But let's see it as an early warning of the seismic shift that is soon to come.
For what has been happening is that the natural turning point of bond markets has been postponed by two things. One is the so-called "flight to quality", which has seen yields for US, German and UK government bonds artificially depressed by ructions elsewhere. The other is the flood of money that has been produced by the main central banks, including our own, in an effort to boost the economies of the developed world. Print a lot of money and it has to go somewhere. One place where it has gone, either directly or indirectly, has been government bonds, thereby depressing yields even further.
There have been other, less significant factors, such as pension fund regulation in the UK, but these are the two big ones.
But nothing is forever. We have just had a 30-year bull market in bonds, but between the early 1930s and 1970s there was a 40-year bear market.
I suppose the signal for change in the UK then was the Labour government going to the International Monetary Fund for an emergency loan in 1976. This imposed fiscal and monetary discipline on us. But the real change was what happened in the US, with Paul Volcker as chairman of the Federal Reserve Board bringing back monetary discipline by increasing short-term interest rates. They went up, inflation came down and eventually bond yields started to fall too.
The big change in global bond markets will have to be in the US and Japan. The top graph shows the size of outstanding sovereign debt in the world. As you can see, Japan and the US dominate the official debt league – they are larger than the big three eurozone countries, Italy, Germany and France, put together.
So how might that shift be triggered? The Japanese and US markets are structurally very different. Japan's debt is very largely held at home; the US debt is increasingly held overseas. Japan is a net creditor; the US a net debtor. Japan has a declining population; the US has a rising one. And so on. But I could see a coincidental shift, with long-term interest rates rising in both markets for somewhat different reasons.
In the case of Japan it would be the gradual repatriation of investments to help sustain the ageing population. People save for their old age, so as the country ages so savings rates come down, as indeed they have.
Thanks in part to higher energy imports associated with the nuclear shutdown, Japan is now running a current account deficit. Meanwhile, the total debt levels of more than 250 per cent of GDP remain an absolute outlier.
While it is impossible to see the process by which Japanese rates will rise, let alone the detail, it is at least plausible that at some stage soon that will happen. There are a lot of voices in the country arguing that this would actually support growth for it would force capital to be allocated with more care.
As for the US, the question is the extent to which its creditors will continue to want to hold sovereign debt: how long will safe-haven status last, or indeed a safe haven be needed? There is the argument that investors have nowhere else to go and the dollar's reserve currency status does give the US and holders of dollar assets advantages. That status will change, but only gradually.
Meanwhile, there may be some other event that will push foreign investors, and here we are talking particularly about China, to diversify their assets. They may want to remain in dollars. A perception that long-term rates do not adequately compensate for long-term risks might push them to other dollar-denominated assets, including equities and property.
They might be wise to do so. The bottom graph, taken from the Equity-Gilt Study 2012 published by Barclays, shows just how much better equities have performed over the past 110 years when compared with either gilts or treasury bills. These show sterling assets but the same would be true of US or continental European ones too. The green line has generally outperformed both the blue line and the red line. If you bought gilts in 1945 and sold in 1976 you would have had a catastrophic loss of wealth. True, we have just had a bad decade for equities and a good one for gilts, but the long-term message is abundantly clear.
A final thought. The British Government does have some undated stock already. It has Consols, short for Consolidated Stock, of which the current batch was issued in 1923 and carries a 2.5 per cent coupon. And it has War Loan, originally issued at 5 per cent in 1917 and then "voluntarily" cut to 3.5 per cent in 1932 – the voluntary element then being somewhat akin to the haircut imposed on Greece's creditors now. Both forms of gilts have at periods in the past offered good trading opportunities if you know when to buy and when to sell, but both have over time been an utterly disastrous investment.
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