Those twin deficits
So the US has the same president for the next four years, and it seems to be a case of ‘better the devil you know’, as far as bond and currency market participants are concerned.
For Bruno Crastes, head of global fixed income at Credit Agricole Asset Management (CAAM), bond markets had little reason to care too much about the outcome of the US presidential election. “In the short term, there really is no impact,” he states. “In the longer term, then yes, perhaps there could be big differences with a different president. With Bush re-elected, this is a negative for bonds because the stated policy is for less tax, bigger deficits, stronger domestic growth but a weaker dollar and with that the threat of imported inflation as well.
“But I think what the election does tell us is that the American people are happy just now. With Bush in charge they are employed, and they still have money to spend.”
So despite the media outpourings on the election outcome, bond investors appeared to ignore it all. Anthony Linehan at KBC AM Ltd in Dublin reviews 2004 and suggests that the biggest surprise of the year is not that President Bush
was re-elected but that yield levels are so surprisingly low. “Suppose that you had asked me at the beginning of this year where 10-year government bond yields would be.
“I would be factoring in the fact that the US Fed would be raising rates, that the US trade imbalance and fiscal position would have significantly deteriorated, that the global economy would be enjoying healthy and synchronised growth and that inflation numbers would generally be ticking up. And I reckon I might have suggested that yields would be 5% or maybe even 5.5%. But instead they’re down around the 4% level.”
“One of the reasons that inflation has not emerged with strength is the remarkable resistance that US consumers have shown to higher prices. Earlier this year, in February/March, we saw them holding back on purchasing decisions until retailers cut prices again. So we have not entered that vicious inflationary cycle by any means.”
“However, as we all acknowledge, the most significant reason for yields remaining so low is the fact that central banks of Asia and Japan have been buying into the treasury market in the process of managing their respective currencies,” continues Linehan.
“Asian central banks have been massive buyers of short-dated US Treasuries, as we know, as they battle to suppress the appreciation of their own currencies and in turn bolster the US dollar. Since 2000 these combined central bank (CB) purchases amount to more than the total net issuance of Treasuries in that time.”
“We know that these bond markets are not focusing on fundamentals just now,” warns Crastes. “The markets are flow-driven with investors looking for yield. And with year-end so near investors do not want to be taking more risk. And as far as many investors are concerned, bonds have been performing so nicely since 1999 they are not as concerned about downside risks as they might have been in the past.”
As a consequence of the stock market sell-offs at the end of the 1990s, investors have been looking primarily for yield, suggests Linehan. “The legacy of the stock market correction is that investors have lessened their search for growth and high capital returns and are more concerned with income and yield.
“This in part explains the solid performance of corporate and asset backed securities for example but does make us now rather nervous as at these levels especially for low grade corporates as we argue that investors may well be underestimating the risks of these types of assets.”
Crastes argues that attitudes in today’s government bond markets appear somewhat similar to those that prevailed during the late 1990s in equity markets, in that buyers will continue to buy something as long as its value continues to appreciate, virtually irrespective of level. “Since September we have had this stream of bond market unfriendly macro news that has not had any impact on the market. Strong growth in the US, inflation clearly edging higher, commodity prices rising strongly and the Fed certainly has hiked rates.
“Look at the reaction to the recent non-farm payroll data,” says Crastes. “A strong figure like that would be expected, in a ‘typical’ market, to cause the 10-year note to drop two or maybe three big figures. Instead what do we see? Only one point, that’s only 15 basis points of yield rise in reaction to such a high jobs number. Investors are convincing themselves that the bond market is such a safe place. We think that bond markets are too extended just now and it is beginning to feel rather like equity markets did in 1999.”
Amsterdam-based Alexander van de Speld, of Insinger de Beaufort, is concerned that the US twin deficits – on its budget and external accounts – will become more and more of an issue for investors in 2005. “We will need to know how it will be sorted out,” he says, “and in 2005 it will probably become more and more of a looming spectre for us all.”
Linehan agrees that in 2005 investors will have to sit up and take notice of the huge deficit. He points out that ‘ordinary investors’, that is, non-central bankers, have not had to worry about the deficits as they haven’t had to absorb the resultant issuance because CBs have been such huge buyers. “So, in a way it feels like investors are living through a (US) surplus environment, rather than the reality of gaping holes.”
“We would argue that the budget deficit is not so much of a problem as these things can be resolved with relatively little pain,” contends Crastes. “Historically deficits have not actually played that big a role in yields, but the current account deficit is a still much more serious problem. But we should be asking ourselves: ‘Is it a problem for the US or for Asia? The Far East needs to run these huge surpluses as corporate Asia does not have sufficient domestic demand to replace the external one. As long as the CBs are happy with this situation then they will continue to finance it.”
Crastes goes on to suggest that a ‘better’ level for the US dollar, that is one that would solve the deficit problem, would be a dollar/yen rate of 70, or dollar/euro 1.80, and significantly higher Asian currencies too. He says: “The Asian central banks are going to keep on selling their own currencies, buying US$ denominated Treasury bonds to try to prevent their own currencies from getting anywhere near these levels. There will a limit to their purchases but we have not got there yet.”
KBC AM’s Linehan would put a low probability on central banks turning right around and selling US Treasury holdings, but he does highlight the worry should the banks just stop buying any more. “If they stopped buying then the rest of the market would have to buy the bonds and soak up all the issuance, which would tend to raise push yields higher.”
So for the time being the impasse remains, and investors sit uneasily shuffling portfolios ahead of year-end. “It is amazing how low volatilities have remained and for so long,” comments van der Speld. “Not just in our (bond) markets but also in equities where vol is at its lowest for years. Look at the Dutch stock market: it began the year at 333, was 333 at the halfway point and as we speak is 338! 0% performance, that’s range trading.”
Van der Speld and his colleagues argue that bond yields are still range-bound and are unlikely to move significantly either way in 2005. “We are sticking with Government bonds rather than investing in credit as we think that spreads are very, very tight and have discounted all good news and do not now represent sufficient reward for the risk they represent.”
Linehan also feels nervous of bonds and is also wary of credit. He says: “The consensus view on the inflation outlook is too benign. There has to be a consequence of all the liquidity being pumped in to the system by the CBs. We think that index linked bonds are a sensible investment just now. As for credit, though the environment is favourable now, that could change. We prefer to look at well-collateralised asset backed securities in our search for yield pick-ups.”
Crastes, on the other hand, is far more pessimistic about bond yields, suggesting that although market dynamics are indeed very bond supportive and these dynamics may remain in place for the near future at least, investors need to be looking at absolute levels. “Investors have an uncomfortable tendency to follow the herd too much. When something is going up they’re all jumping in as well. Sometimes they forget that things can turn around. We believe we must focus on absolute levels, not on who is doing what.”