Bonds had quite a ride over the past week. European bond yields, in particular, lifted off from their all-time lows; but the move’s speed and magnitude surprised investors.
French and German Bond Yields Rocket Off Their Lows
Source: Bloomberg
As readers are aware, the values of bonds move inversely to their interest rates. Last week, as rates spiked higher, the global bond rout is estimated to have erased about 0 billion in value.
We commented in our last letter about the risks of volatility in some bond markets due to liquidity issues. Last week’s sudden moves underline those concerns and add a few more.
What’s Going On?
Broadly, there are two possibilities about what the recent moves mean.
First, they could indicate the beginning of a fundamental reassessment by markets of inflation and growth expectations. Negative yields across Europe would only make sense if markets were anticipating a prolonged struggle with deflation. If deflation fears were genuinely being replaced by signs of “green shoots” of growth and hints of coming inflation, a rebound in yields would be expected as markets priced in new anticipations. The rebound in oil noted above, as well as a possible rebound in other commodities (such as base metals), may also be reshaping inflation expectations.
There are a few problems with this view. Such “green shoots” as there are, are small and still hard to see; Europe has some deep and intractable economic, social, and geopolitical problems, and the strong rallies in European equity markets this year have had much more to do with the initiation of QE than with any resolution to those problems coming into view. Japan has its own set of problems; and while the picture in the U.S. is brighter, we do not see enough to justify any vigorous growth and inflation expectations.
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Also, such a view to explain the recent bond swoon implies that bond markets are actually doing what markets are supposed to do — sending price signals that convey participants’ views of the future. However, as we know, bond markets since the introduction of QE have become sufficiently distorted that it’s hard to discern real information in their price movements. This is perhaps particularly true in Europe, where liquidity constraints have caused market participants to wonder whether the European Central Bank will even be able to find enough bonds to buy to fulfill its QE program.
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Second, last week’s sudden moves may not clearly indicate the market’s reassessment of medium-term expectations, as much as near-term technical developments. The rout developed as speculators took profits and started a feedback loop. Of course, objectively, taking profits made sense for “hot money” speculators — with rates in uncharted negative territory, staying in for more gains begins to look like picking up nickels in front of a steamroller.
Which View do We hold?
There are data to support both points of view. It may well be that market participants are catching their first whiff of inflation, and that they’re encouraged at the prospect of a European recovery. It may also be that speculative bond-holders are cashing in as they count their gains and anticipate rate increases at some unknown but inevitable and probably proximate future date.
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But we take a simpler perspective — rates, particularly in Europe, have reached absurd levels. No one knows when yields will rise, whether from central bank policy shifts, a pickup in global economic activity, rising inflation expectations, rising commodity prices, and so on. But we can say that even if bond yields do not rise violently — even if the recent price action is more technical than fundamental — with yields at centuries-long lows, the money in the long bond rally of the past 30 years has been made. We may see bonds rally again and experience further volatility… but the writing is on the wall: rates must eventually rise, and can’t fall much further. The message we take from last week is simply that the risk-reward profile for bonds looks very unattractive to us. The bond rout shows that at least some other market participants are beginning to think the same.
More Volatility on the Way
Further, volatility in bond markets is likely to increase. Long-duration bonds are more volatile simply as a result of bond math — the greater the duration, the more the bond’s value responds to rate changes. So an instrument such as the iShares 20+ Year Treasury Bond ETF (NYSE: TLT) can decline rapidly as the yield curve steepens. These instruments will not be safe havens as yields reverse their decades-long decline trend.
Further, as we pointed out last week, other bonds that have become high-yielding favorites in bond funds (such as emerging-market and high-yielding corporate debt) and ETFs. The underlying bonds are not anywhere near as liquid as the shares of the funds that hold them. Big market participants may not be as willing to step in and buy as they have been in the past — so the risk of a cascading sell-off in thinly-traded instruments becomes greater, and could produce extreme volatility in high-yield bond ETFs. Small changes in supply and demand could have outsized impact on prices, and produce painful downside moves. We also read one comment from an analyst which gave us pause: “Pretty much all funds now have the ability to restrict redemptions in the event of liquidity problems, and this is a real risk in the bond fund sector.” That is not language that makes us sanguine about the risks involved in holding bonds.
Investment implications: Last week’s global bond rout may or may not indicate the beginning of a sea change in bond markets or a fundamental shift of bond investors’ views on growth and inflation. However, whatever the cause, we think it safe to say that at this point, upside gains in bonds have been realized, and when rates begin their inevitable rise from the zero bound, losses and volatility look like clear risk against a small and uncertain reward. Whether in the near or medium term, the fixed-income picture is clouded by volatility and capital risk. We are not bullish on bonds, and we caution readers to review their holdings of bond funds and to evaluate the liquidity of the underlying instruments.
For more commentary or information on Guild Investment Management, please go to guildinvestment.com.
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