This story by Tim Bond in Thursday’s Financial Times, provides an excellent explanation of how a change in the universe of bond investors has produced new outcomes, like a difficult-to-explain negative yield curve. It also looks prescient in light of the plummet in long-dated Treasuries that day.
Bond’s article says that “long term bonds are about one percentage point below their equilibrium value.” That translates into a very large price differential at current rate levels.
The culprit is foreign central banks that have been accumulating dollars due to our trade deficits and parking them in Treasuries, and also (more recently as the dollars continued to roll in) moving into riskier assets, plus regulatory changes that required some institutional investors to shift their asset allocation in favor of bonds.
From the FT:
Global bond markets have been in a bubble for so long that many participants are in danger of forgetting it exists. Some recent investment decisions can only be rationalised on the basis of a belief in perpetually low and stable bond yields. To the extent that such expectations are extant, they are likely to be disabused over the next year or so.
We need to recall that over the past five years, bond markets have exhibited a significant change in the way they react to economic fundamentals. Relative to comparable points in past economic cycles, bond yields are now much lower and yield curves much flatter than would typically be the case. Since both central banks and bond investors respond in a predictable manner to economic fundamentals, this change of bond market behaviour can be quantified with some precision. Predictability of response allows us to use econometric techniques to model short- and long-term interest rates. These models show us that while short-term or official policy rates are more or less where they should be, given the current economic environment, longer-term interest rates are about one percentage point below their equilibrium value.
The obvious explanation for any market anomaly is a disruption to the usual patterns of supply and demand. In this instance, the bond market is no exception. The bond market “conundrum”dates back to 2003. In that year, the global demand for bonds surged. The main source of this excess demand was a jump in global foreign exchange reserve growth, which accelerated from annual growth of $75bn in the previous decade to as much as $800bn by 2004. In tandem with accelerating reserve growth was an increase of some $300bn in bond purchases by pension and insurance funds. This latter shift in asset allocation – which was mirrored by a decrease in equity purchases of a similar magnitude – was driven by regulators tightening solvency requirements for the relevant institutions.
With a horrid inevitability, the largest equity sales were at the bear market lows, the largest bond purchases at bond price highs. The total of reserve manager, pension fund and insurance company bond purchases rose from an average 30 per cent of net bond supply to over 100 per cent in 2004. Although this appetite has slowed somewhat over the past two years, it remains equivalent to 60-70 per cent of net bond issuance, double the historic average.
The side effects of this depression in bond yields have been dramatic. The displacement of orthodox bond investors out of government bonds into corporate bonds and derivatives has generated the easiest credit conditions seen for a generation. The one percentage point or more depression in bond yields has not been replicated by a similar depression in equity yields, leaving equities priced at extremely cheap levels to bonds. This has spurred companies to releverage.
The surge in global economic growth, commodity prices, property prices, LBO activity, private equity deals and general M&A similarly testify to the effects of the financial Viagra conferred by low long-term rates.
However, these trends contain the seeds of their own reversal. Corporate releveraging is sharply increasing the overall supply of debt instruments, while simultaneously decreasing the supply of equities. On the demand side of the equation, the extraordinary size of FX reserves is prompting global reserve managers to diversify away from low risk bonds into higher return assets. China alone may be responsible for a redirection of capital away from bonds and into equities worth some $300bn-$400bn over the next 12 months or so. Like all markets, both bonds and equities are subject to the inexorable law of supply and demand. While this redirection of capital flows will initially benefit equities, we can be sure that the impending increase in bond supply and decrease in bond demand will lead to a gradual deflation of the great bond bubble. As this process unrolls, we can be equally sure that the expected returns underpinning many recent investment decisions will be subject to a similar deflation of prospects.