Hamish McRae: Plans for 100-year bonds mark end of bull market, but equity bear still prowls
In global finance, the Budget may mark the beginning of the end of cheap money
Sunday 25 March 2012
So the Treasury will in the weeks ahead explore the idea of issuing 100-year and maybe even undated debt. The Chancellor confirmed that in his Budget speech and one of the intriguing things to look for in the coming weeks will be whether there is indeed a market for the stuff or whether the fact that the idea of undated stock should even be floated is a classic sell signal – a sign that the 30-year bull market in fixed interest securities was over.
When I first mooted this possibility a few weeks ago it seemed a "neck-sticking-out" notion. Trying to call a turning point of a 30-year trend is really a bit ridiculous, for the chances of getting the timing of great turning points that occur only once in a generation must be tiny. In any case, the thing that turns long-term interest rates will not be something in the UK: much more likely to be something in the US or even China. But in recent days several things have happened that would seem to support this view: that a huge shift is taking place that will affect us all for years to come.
In the world of British politics George Osborne's latest Budget may be remembered for the ending of the 50p tax rate or the so-called raid on pensioners' incomes – two elements of the Budget that are in economic terms utterly irrelevant. But in the world of global finance it may come to be one of the signals that will mark the beginning of the end of cheap money.
The main graph shows the great bear market in US bonds, followed by the great bull market. Back in the early Fifties 10-year US government securities carried an interest rate of a little over 2 per cent. They then climbed to reach a peak at the end of the Seventies of 16 per cent, as the red line shows. Then they fell to just 2 per cent at the end of last year. The value of a bond obviously is inverted: the higher the yield the lower the price of any existing stock, and vice-versa.
Since the beginning of this year, however, yields have started to climb: they were around 2.25 per cent on Friday. Much the same pattern applies to UK gilts, and people who spend their lives looking at these things are wondering whether something similar is happening to German bonds. There was a note on Friday from UBS headed: "Bear market for Bunds too?"
If this proves right the three main "safe haven" sovereign debt markets will have all turned some sort of corner. That is not because of any rise in confidence in the eurozone, where the jitters have returned in the past few days. Nor is it the result of any new doubts about German fiscal probity, indeed rather the reverse, for Germany is following through on its plans for a balanced budget by 2016.
So what might be turning things around? It is far too early to be able to say anything with confidence and we won't have much of an explanation until long after the event. But there are two broad theoretical explanations.
One is that the global recovery is picking up and confidence is rising. As a result short-term rates will eventually rise to reflect this and, meanwhile, there are other investments, such as equities, that look to be a better prospect.
The other is that the central banks have printed billions of money and that this money will end up in higher inflation – in which case fixed interest securities will be catastrophic investments, as they were in the 1950s, 1960s and 1970s.
It would certainly be common sense to observe that any government security is based on a promise to pay back the money, and that this promise is, in turn, based on the taxing power of the sovereign state in question. Given the adverse demography of most of the developed world, with the partial exception of the US, that taxing power is rather in question.
It would be in question without the additional borrowing of governments associated with the recession. The UK, for example, will have tripled its national debt between 2007 and 2017.
Obviously, any finance minister has a duty to try to borrow as cheaply as possible. The question is whether savers are prepared to lend the dosh to enable him or her to do so.
That leads into a debate about the alternatives, of which obviously equities are the main alternative class. Interestingly, as Chris Watling of Longview Economics points out, you can have both bull and bear equity markets within a bull or a bear bond market. Thus the recent long bull market in bonds had a bull market in equities that lasted from the middle of the 1970s to 2000, then a bear market from then till 2008.
Again, it does not matter much whether you take US equities, UK ones or indeed any other major market – bar Japan, which is special to itself. All developed markets move more or less in convoy with each other. But you do have to ask whether shares are fundamentally cheap or fundamentally expensive to have some sort of way of deciding what to do in the event of a bear market in bonds.
You can take a common sense approach and look at price/earnings ratios and if you do, UK shares certainly seem reasonable value. The right hand graph, taken from the Barclays Equity-Gilt Study shows that the median p/e ratio since 1969 has been a little under 15.
Shares now are not screamingly cheap as they were at the beginning of 1975, nor absurdly expensive as they were at the end of 1999. But they are not badly priced, certainly when you consider that they do give some sort of protection against inflation. US shares are a bit more expensive than UK ones on this measure; German shares a bit cheaper.
So we don't have to buy George Osborne's 100-year debt, and if he does launch it, I suspect it will become one of the most notoriously disastrous investments of all time.
Footnote: On Friday Bill Gross, the head of Pimco, the world's largest bond fund, tweeted: "Bond mkt may be dead but bear mkt remains in the distance". So there.
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