The developed world's government bond markets are showing characteristics of a bubble. Timing the end of this rally won't be easy -- but for those watching closely, hints are emerging.
From Silicon Valley to the South Sea, bubbles can swell anywhere. Today, it's arguably the turn of the developed world's artificially overheated government bond markets. Government bond market valuations are at extremes, and yet the buying persists. The trend is provoking fears that bond yields are entering bubble territory. Negative rates, after all, virtually guarantee that investors will earn a negative nominal return on their bonds. However, bubbles are not defined by valuation alone. We also need to consider four elements that tend to be present in a speculative market environment.
1. A sound rationale
Every bubble has a rational underpinning. Intuition and logic allow investors to embrace a particular market or trend, but their excitement ultimately spirals out of control.
The dot-com bubble of the late 1990s is an example of how a seemingly transparent story can go awry. Then, just as now, there was considerable confidence that technology was capable of revolutionizing nearly every aspect of society and that many companies would be transformational and generate super-normal profits. But investors became indiscriminate, failing to distinguish the value-adding firms from the imposters. The underlying rationale never wavered, but it gave investors the excuse to drastically overpay for companies.
Interest rates are low today for a very simple reason: Growth and inflation are low and are likely to remain so. Global GDP and global inflation have a long history of correlating strongly with interest rates. The current cycle is no different and supports investor intuition that rates should be depressed. So far, so good, but it's not the same as saying yields should be this low.
2. It's different this time
Investors believe today's supportive bond market conditions will never end. Is it different this time? Yes. Policy rates are currently at or close to the zero bound in many markets. But this has done nothing to elevate inflation and growth expectations -- a phenomenon that has converted many to the "secular stagnation" thesis. The premise is that if policymakers are bound by rates close to zero, they may not be able to engineer a rate low enough to spur demand, particularly if inflation and corresponding rates of return are insufficiently low. And if recessionary pressures build in the coming quarters, central bankers will have seen an entire cycle pass without ever being able to meaningfully hike rates.
Furthermore, we are seeing unprecedented debt loads. In theory, artificially low borrowing costs should engender explosive credit growth in the private sector. Corporations and consumers alike should be eager to borrow at low rates and invest the proceeds into something productive. But corporations, beset by overcapacity and woeful productivity, are reluctant borrowers. And consumers ended the last cycle with so much debt that they seem unwilling or unable to re-lever at any price. Policymakers have no choice but to keep debt servicing costs as affordable as possible.
Finally, the paradox of thrift appears alive and well. Low interest rates are meant to encourage people to spend, stimulating the demand side of faltering economies. Yet, seeing no improvement in their earning power, many consumers are saving more, not less, to compensate for scarce investment returns. Monetary policy is largely exhausted, leaving central banks with limited scope to raise rates. It is understandable that bond markets have responded by pricing in a lack of growth and inflation over the short term. But the market has done much more than this, assuming there will be no pressure over the long term.
3. A visible hand instills confidence
The so-called visible hand, a buying force that is both powerful and visible to all, invokes a high level of investor confidence that the trend is long-lasting. In today's fixed-income bubble, central banks are that visible hand, and it shows up daily in the form of quantitative easing.
Central banks are purchasing billions of government bonds in their bid to stimulate global economies, artificially propelling prices higher and yields lower. The Bank of Japan, for example, is purchasing more than $700 billion of Japanese government bonds every year. Central bankers are the bull in the china shop, distorting prices and making other market participants wary of fighting the trend even at seemingly nonsensical prices. The highly public nature of this large-scale buying creates confidence that someone will be around tomorrow to buy at an even higher price and that any selloff will be contained.
4. An invisible hand fosters complacency
Finally, there is an invisible hand often working to propel prices higher. These are the flows that are more difficult to spot and even more difficult to decipher, but they seem to repeatedly come to the rescue of markets and foster investor complacency.
Globalization has greatly expanded the influence of international capital flows. China and Japan have both had a significant downward influence on global rates. China's capital outflows have put immense pressure on global real rates and the so-called term premium - the yield advantage gained by extending maturity along the yield curve. A savings glut, slowing business investment and worries over potential devaluation in the yuan have all provided the impetus to move money offshore. Likewise, as the Bank of Japan buys bonds from other holders, the proceeds received by sellers have found their way into higher yielding offshore markets, pushing global yields lower. The same can be said for the European Central Bank.
Pension funds and insurance companies require assured income to meet the promises made to savers and policyholders. Many have liabilities exceeding the duration and maturity of their assets. Lower yields worsen this mismatch, creating an acute need for many of these players to add more duration as yields move lower. Other financial institutions, such as banks, are being forced through regulation to add more safe assets. Together, these powerful forces have exacerbated the procyclical behavior of other investors.
How low can yields go?
For years, U.S. and European investors have anticipated a rise in interest rates. It has never materialized, as we have instead witnessed a series of global deflationary shocks. We cannot rule out further declines in yields. Geopolitical uncertainty remains high. Central banks may boost bond buying and/or cut rates even further in a bid to boost growth prospects. Growing recessionary fears might delay lift-off. Yet there are numerous indications that we have reached the end of the road.
First, short-term policy rates have largely moved to the lower bound. Although there may be scope for additional minimal rate cuts outside of the U.S., they will be largely cosmetic. Markets have rejected deeply negative rates and policymakers risk unintended consequences should they pursue this option.
Long-term yields can be thought of as a combination of the forward path of short-term policy rates and a term premium to compensate for additional risk of lending for a longer period. If rates are to fall meaningfully, it must come from one of these sources. If we rule out further declines in short-term policy rates, we eliminate one tailwind for bonds. The difference in this cycle is that the term premium has already become very compressed, effectively eliminating the other potential tailwind. This combination tells us the rally is in its final stage unless a massive deflationary wave is imminent.
When will the bubble burst?
The million-dollar (trillion-dollar?) question for investors is when the bond bubble might burst. Unfortunately, in today's unusual environment, traditional indicators offer few clues. Changes in any one of the four elements discussed could deflate the bubble.
The most likely place to search for clues will be in the visible and invisible hand categories, especially in Asia. Japan is at the forefront of policy experimentation and is becoming desperate to boost inflation expectations. It might just be successful, either by forceful actions to achieve its inflation target or by formally adopting a price level target. A recovering Chinese economy might be another catalyst for the end of the bond rally. Chinese investment flows have materially suppressed global bond yields. A reacceleration in China would force foreign flows to rapidly recede, leaving government bonds without a key source of demand. Investors should keep a close eye on China's growth rate and the pace of capital outflows. In other regions, a less accommodative stance by either the ECB or the Bank of England would greatly exacerbate a sell-off.
If the good times are over, what's next?
A final important lesson of bubbles is that they tend to end badly. But, they also end quite differently and very often through unexpected channels. In the meantime, products with low exposure to core developed market government bonds or low interest rate sensitivity should continue to do well. Products that can aggressively allocate to different sectors, or that emphasize non-core government sectors such as credit, municipal bonds and emerging markets, should prove to be the most resilient areas of the fixed-income market, albeit with a heightened degree of volatility.
We are witnessing the end of a multi-decade rally, and the unresolved question is simple: Must we wait a long time for this bubble to burst, or is an abrupt end just around the corner? The answer is not entirely clear, but will likely come from unexpected places and will be heavily influenced by policymakers. Warning signs are looming.
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