A brutal May, a flat June, a happy July and then a lousy August – the equity markets continue to lurch alarmingly along a directionless path, with every monthly lurch seized on, by those with the strongest views, or at least the loudest megaphones, as evidence that their interpretation of events is right. It was not, fortunately, ever thus and nor will it be forever. In due course, we will find out in which direction the equity markets really want to go. My money still favours that direction being up, rather than down, but it could take one more painful downleg before the trend is finally established.
Over in the bond markets, meanwhile, the contrast could not be more marked. A near 30-year bull market remains, for the moment, firmly intact. An entire generation, we can now see, could have lived happily ever after, in real as well as nominal terms, merely by placing a single bet that bond yields would continue to fall. In a world gripped by powerful global disinflationary forces, and starting from yield levels that had touched record historic highs after the inflationary 1970s, the bet was logical – but its durability was not.
For almost the entire first 20 years of that bet, it is true that investors could have done even better by buying equities as well. For the last 10 years, in aggregate, they could not have done much worse. Thanks to the global banking crisis, the 2000s will go down in history at the decade which showed up the limits of multi-asset diversification as a risk management strategy. Liquidity proved to be a critical missing ingredient for those who followed the Yale model too slavishly.
The search for liquidity is one reason for the current resilience of the bond market. Despite an unprecedented amount of monetary stimulus, record inflows have driven yields all along the curve to their lowest levels for not just one, but in some cases two, generations. As the bond managers at M&G pointed out, for the first time in living memory not one UK gilt was priced to yield as much as 4% last week. In the US, Germany and Japan, across the entire maturity spectrum, new yield ceilings have been established in the past three months at 4%, 3% and 2% respectively.
By the standards of the 20th century these are extraordinary figures which, if taken at face value, imply that inflation is not only dead but more or less permanently buried. In the short term they seem to point not just to a double dip recession, but to outright deflation continuing for several years. To purchase and hold to maturity a long-dated US Treasury or UK gilt at today’s yields is a remarkable act of faith in an unproven thesis.
There are of course reasons why owning Government bonds today at record low yields can be rationalised. Some investors, we know, are required to own long-dated bonds, whatever the price. With the economic data so uncertain, it is by no means impossible that bond yields could go lower from here, creating the potential for trading gains. Bonds still have a certain amount of diversification value, though how much is open to question, since diversifying assets are only sure to diversify effectively when they are the right side of fair value. Probably the simplest reason though can be summed up as “don’t fight the Fed”.
The US central bank has an explicit objective, reaffirmed the other day by Mr Bernanke in his Jackson Hole speech, of bringing down bond yields right along the yield curve. That commitment needs to be taken seriously. A new bout of quantitative easing is almost certainly on its way. The beautiful paradox is that while Mr Bernanke has a personal mission to eliminate any risk of a rerun of 1930s deflation, if he is successful it will in due course undermine the case for owning bonds at the prices he is moving heaven and earth to bring about today.
Yet in the short term, despite the bond market trading at artificially depressed yields, many investors continue to buy the deflation story. There is comfort in numbers. But it is not hard to predict that this trend, however long it still has to run, is not going to end well. Professor Jeremy Siegel of Wharton says that investors who pay 100 times the yield to own a US government bond are participating in a bubble which is every bit as extreme as that involving Internet stocks in 2000. Nassim Nicholas Taleb, author of the Black Swan and Fooled By Randomness, says that “every single human being” ought to bet against US Treasuries. It is a “no brainer” of a bet.
It is the nature of climactic moments in markets that warnings tend to count for little when momentum is running strongly in the opposite direction. The Queen was puzzled enough by the global financial crisis to demand to know why nobody apparently saw it coming. Mr Obama won’t be able to say the same about the coming fallout in the bond markets.
Jonathan Davis has a new blog at http://iidaily.wordpress.com