Going down, and down, and down
As government bond yields throughout the developed world continue to fall ever lower, and equity markets remain severely damaged to say the least, the need for explanations or reality checks becomes stronger. Drawing on previous experiences is one of man’s most useful abilities but today’s environment feels to many, perhaps the majority, very different indeed to anything that’s gone before.
However, there are similarities to the past, perhaps not seen to Europe, but in the US in the early 1960s and Japan throughout the 1990s. Most investors won’t have first hand knowledge about investing in the US in the 1960s but events in Japan are certainly better appreciated, if rather grim.
Dresdner Kleinwort Wassertein’s global strategist Albert Edwards believes that today’s world is indeed exhibiting similar traits to these times. He has termed this environment, characterised by near-zero inflation and lower returns in equities relative to bonds and cash, as an ‘Ice Age’. Edwards’ colleague John Butler, who heads up the global debt strategy team, has put forward his ideas for the implications such an Ice Age would have for bond markets.
He comes up with several themes to follow, some of which seem more obvious than others. In an Ice Age, with such low inflation, he points out that nominal bond yields would, unsurprisingly be unusually low. He also argues that real yields would also be lower than during the 1980s and 1990s because the perceived risk premium on equities would be rising and investors would be more willing to pay for the relative certainty offered by bonds and so real yields would be trend lower.
Butler’s next forecast concerns yield curve shapes, where he argues that as we leave the equity bubble and move into the Ice Age, yield curves would be steep but as things begin to freeze, the flatter the yield curve would become. Butler agrees that this may seem somewhat counterintuitive, as expectations for rate cuts normally steepens curves. However the lower short rates get, the more limited potential returns at that end so the market enters what Butler calls a ‘duration paradox’ where duration is no longer a meaningful concept for comparing expected returns at the short and long ends of a yield curve. Because central banks cannot cut rates below zero, there cannot be a true parallel curve shift and the only way to profit is to move further along the curve to get carry.
1960s America never entered this ‘duration paradox’as the Fed didn’t cut rates to zero and inflation never gave way to deflation. Japan, on the other hand argues Butler, does offer an example for how the current steep US curve might evolve in the transition to an Ice Age. He suggests that even if the Fed does continue to cut rates that the steepening trend is over. The 10-2 year JGB curve steepness topped out at around 250 basis points, close to the recent high witnessed in the 10-2 year US Treasury spread.
Once in the Ice Age, however, Butler suggests that investment-grade corporate bond spreads should narrow, though this process could be a slow grind in the face of high default rates. This is due to both diminishing supply of corporate debt and an increase in Government bond supply that is likely as long as growth remains below trend.
Butler also argues that swap spreads would narrow, as corporates are likely to issue less debt and banks become more reluctant to lend. And what do the banks, awash with cash if they don’t make loans? Buy government bonds and other low-risk securities, a process that Butler points out has already begun in the US and has certainly been the case in Japan (albeit for a variety of other Japan specific reasons too).
In the absence of a swap market in the 1960s, Butler draws comparisons with the 1991-1994 period when corporate supply was falling, government debt was on the increase and banks were not lending much. During this period swap periods tightened as yield curves steepened but hardly widened at all as curves flattened by some 200 basis points between 1993 and 1994.
In summary, if you think we are indeed in transition to an Ice Age, then you’re already overweight bonds versus equities, and underweight low-rated credits and emerging markets. And if you believe we are already in that Ice Age – low inflation, very low interest rates, equity markets far from their highs, corporate spreads very wide – then start switching into investment grade corporate bonds.