by John Butler, GoldMoney:
The large global bond market selloff of late has naturally elicited much commentary from investment strategists and the financial media. By some estimates as much as $1tn in bond value has been wiped out. That is a large number. But what is behind the selloff? Did expectations for Fed rate hikes suddenly surge? In fact, rate expectations have risen only modestly, perhaps in reaction to president-elect Trump’s expected fiscal stimulus plans. More important has been a large expansion in so-called ‘term-premia’ for longer-dated bonds. Term premia represent the additional yield bondholders require for holding long-dated bonds as opposed to short-dated paper. When premia fall, so does the real cost of long-term borrowing and vice-versa. This is why recent developments are of such interest, as premia have remained structurally low for years. In this report, we explore the implications of a premia reversal on financial assets, the dollar and gold. In brief, gold is highly likely to outperform financial assets in this environment, although not necessarily the dollar itself. The key to the dollar is to understand the Fed’s reaction function to the above.
Although it may have coincided with president-elect Trump’s surprisingly successful campaign, in fact the global bond markets have been indicating that a trend reversal might be underway for some time.
On trend, yields have been declining for many years. However, in 2016, there had already been a notable loss of momentum. The great global bond market rally had, for the most part, ground to a halt. Central bank policy rates were already zero to negative in most of the developed world, and commodity and consumer price inflation had begun to trend higher again, if only gently in most economies; so it was understandable that the bond market rally was probably nearing exhaustion.
However, Trump’s election appears to have awakened the so-called ‘bond market vigilantes’ from an unusually long slumber. Why? It is well-known that Trump has said he will cut taxes—most Republican presidential candidates have done so historically, especially amid a weak economy—but it is not at all clear how he plans to prevent this leading to a surge in the deficit. Hence there is a general expectation that some fiscal stimulus might be on the way under Trump’s administration. That could be negative for bonds.
Regardless of the catalyst, the reality is that bond yields have soared of late. When looked at in risk-adjusted terms, the carnage has been historic. Many investors measure their returns in this way, that is, they place returns in the numerator and divide them by the volatility of that return stream. This risk-adjusted return concept, primarily associated with Nobel-prize-winning economist Robert Sharpe, can be applied to all assets in theory, but is most commonly applied to relatively liquid assets which can be liquidated at any time in large amounts without materially affecting the overall price in the market for the assets in question.
By way of example, imagine for a moment a bond yielding 5% losing 10% of its value. Using simple math—excluding compounding effects, etc—this selloff wipes out two years’ worth of that bond’s returns. Now imagine a bond yielding only 1% losing 10%. This results in that bond losing 10 years of returns. Presumably, given that investors, like all people, care about returns over time, the latter loss is more painful than the former. With bond yields currently so incredibly low in a historical comparison, yet with volatility now having surged and produced huge losses, the ratio of the numerator to denominator is thus at a historic low point, probably the lowest within the lifetime of anyone investing today and perhaps reaching back multiple generations. It is indeed historic.
Looking behind the sell-off, what we see is that it was primarily the result of a rise in so called ‘term-premia’, which is the compensation that investors require to assume an exposure to unexpected future path of long-term interest rates. (It is important to distinguish carefully between actual rate expectations, and the uncertainty premium added on top. The latter can be derived by subtracting the forward short-term interest rate as visible in the futures markets from the long-term eg 30y interest rate.)
As with all things in investing, uncertainty requires compensation, or no one will accept exposure to the uncertainty in question. While ultimately all calculations of uncertainty are subjective, so is the determination of term-premia. There is no ‘right’ answer, just the market’s determination of what constitutes fair compensation for risk at any given point in time. The market price is thus that which clears the market, in this case that for long-term interest rates.
When it comes to government bonds, there are multiple sources of uncertainty. The future price level is uncertain. The supply of bonds vis-à-vis other assets is uncertain. The underlying currency of the bond might swing around in value, something of particular concern to international investors. The bonds might, in extremis, be defaulted on, although this is exceedingly rare in the case of governments with access to a printing press, as most governments have, with the notable exception, at present, of euro-area member countries.
Regardless, uncertainty, and the volatility associated with it, is both the investor’s friend and enemy. There is no return without risk and, to the intelligent investor at least, no risk will be taken without a sufficiently attractive potential return. The trade off in question may be relatively small in the case of government bonds given their perceived safety. But here, too, safety is in the eye of the beholder. Do governments always make good on their promises? Of course not. But unlike financial analysis, such as that which can normally be done with corporations and their balance sheets, income statements, cash flows, etc, government finances are so opaque and the political risks so qualitative in nature that they normally defy any robust quantification. Indeed, one could argue that many investors simply place their ‘faith’ in governments. However, history instructs that this can be a dangerous mindset at times.
Returning thus to the recent sell-off, there is simply no way to know what mix of the above risk factors is behind it. We can speculate, but not analyze in any detail. If we just accept rising uncertainty for what it is, however, we can derive certain implications for the financial markets, the dollar and gold.
The shift higher in uncertainty, should it continue, implies a higher cost of borrowing, other factors equal, such as the specific growth/inflation mix in the economy. In other words, growth may be weak, as we know, and inflation may be low (if rising), as we also know, but for whatever reason, if investors are now demanding more compensation for holding bonds, then borrowing costs can rise regardless. This additional compensation must come from somewhere in the economy, and so it leaves less on the table for those who would use that particular slice of available funds to spend instead. As such, it will reduce the potential growth rate of the economy. With global commodity prices probably having bottomed out at this point, the net result is likely to be one of ‘stagflation’.
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