The period of maximum danger for bond investors is yet to come

Maximum danger for bonds investors will come when European growth strengthens and US inflation rises
Does the Federal Reserve have a credibility problem? That certainly is the view of Narayana Kocherlakota, former president of the Minneapolis Fed, who argues that investors have lost faith in the Fed’s ability to hit its 2 per cent inflation target and that the time has come to reverse course and ease policy.
Other critics highlight the Fed’s poor record in forecasting economic growth and inflation since the financial crisis. Futures markets, meantime, have determinedly refused to price in interest rate hikes that the Fed has promised.
On the face of it, this is bad news because it implies that businesses, consumers and investors are having to make decisions on the basis of confused and confusing signals about the central bank’s intentions. But before condemning the Fed out of hand, it is important to recognise that the US central bank is not alone in this. To take the extreme case, the Bank of Japan under governor Haruhiko Kuroda announced in April 2013 that it expected to reach its 2 per cent inflation target in about two years. It remains miles from its goal.
The reality is that there is no major central bank in the world that has not been challenged on this front. Nor can anyone be entirely sure how the real economy works in the aftermath of the crisis. As I have argued here before, the current mantra that policy will be data-dependent is an open acknowledgment of that fact. Last week’s unexpectedly poor employment numbers underline it yet again.
Apart from this crisis-induced fog of ignorance, the difficulties for policy come at several levels. To start with, the divergence between the economies of the US on the one hand and the eurozone and Japan on the other is unhelpful, especially against the background of the global savings glut. With the European Central Bank and the Bank of Japan still in extreme loosening mode, any hint of a US rate rise causes capital to fly from negative interest rate territory to the US, where Treasuries provide a handy pick-up in yield.

The dollar strengthens as a consequence, hitting corporate earnings and causing the stock market to fall. Financial conditions are thereby tightened, the next interest rate rise is deferred and the Fed’s forecasting record is cast in an even poorer light. And when the Fed does raise rates, as it did last December, the impact on the Treasury yields is minimal. In the absence of stronger growth in the eurozone and Japan, normalisation of monetary policy in the US will remain elusive.

For investors, the circularity of this process leads to the all-too familiar alternatives of reaching for yield or running for safety. But what is safety when more than $10tn-worth of government debt shows a negative yield and the average yield on German government bonds has just fallen below zero for the first time? The valuation basis of the bond market looks horrible but one brutal lesson of the post-crisis world is that what looks horrible today may look even more horrible tomorrow.
Yet the experience of previous recoveries from great financial crises is that after a few years of reflation, in which both equity and bond prices rise, bond market returns dwindle or disappear.

According to Jonathan Wilmot of Credit Suisse Asset Management, in the aftermath of the 1890s Latin American debt crisis real US bond returns from 1900 to 1910 were minus 1 per cent a year. The comparable figure for 1939 to 1949 after the Great Depression was minus 2 per cent a year.

After these two episodes, investors’ peak-to-trough losses in the US bond market were, respectively, 50 per cent from 1900 to 1920 and 65 per cent over the 40 years from 1941 to 1981.

The figures for the UK were even higher.

Given today’s high level of public sector debt and worsening demographics, it is inevitable that governments will resort to soft forms of default, including inflation, to escape from their fiscal straitjacket.

This is a world in which elderly savers will be condemned to subsidise borrowers for a long time. The period of maximum danger for bond investors will be when growth in Europe strengthens and Fed policy gains potency — and maybe even credibility — as a result.

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