A safe assets bubble

The financial history of the 21st century is the story of bubbles and the after-effects of bubbles in different asset markets. In March 2000, the TMT bubble burst leading to a near 80% decline in the NASDAQ Composite Index over the next few years. The response of the Federal Reserve took interest rates down to 1% and held them there until it was clear that the economy was recovering – this policy of very cheap US dollar borrowing led directly to (i) the US housing market bubble and (ii) explosive growth in the financing of a wide range of assets, the emergence of the “shadow banking” sector and a bubble in the credit markets. The Global Financial Crisis in 2008 burst those bubbles and led to a severe global recession as the world’s financial system seized up. The Chinese government decided to seek to offset the damage to its economy with an enormous surge in infrastructure spending which created bubbles in their equity market and in many commodity markets. The weakness in global growth since then has meant that the recovery expectations of central banks have been consistently disappointed and led to them pursuing Quantitative Easing (QE) in ever-increasing amounts.

To date the 21st century has suffered bubbles in developed market equities, real estate, credit, emerging market equities and commodities – all assets that are to some extent seen as risky in investors’ portfolios. However the continued and repeated application of QE has now created a bubble in government bonds – the quintessentially “safe” assets for investors.

The hallmark of a financial asset bubble is when traditional valuation concepts are ignored by investors and the bubble asset is purchased because of a belief in the greater fool theory – that is confidence that when you want to sell there will be a buyer prepared to pay an even higher price – in these situations asset prices tend to rise to far higher levels than sensible investors can imagine.

The FT last week calculated that some $13.4 trillion of global government bonds now offered negative yields – a negative yield means that investors are paying to lend money to governments. They know that buying these bonds will result in them losing money if they hold them to maturity. Their rationale for continuing to hold them must be either (i) they are forced by law or regulation to hold them, (ii) they will suffer worse negative yields if they sell them and try to deposit the cash or (iii) they believe they will be able to sell them at a higher price (and more negative yield) to another investor in the future. Most of these negative yields are in Europe and Japan but even in the UK and the US most government bonds yield less than 1% and all global index-linked government bond yields offer negative real yields.

With central bank QE programmes continuing to be forced buyers of government bonds, the marginal buyer of these bonds is not price-sensitive and so a case can be made that prices of these bonds may go even higher, but investors should be aware that these are bubble valuations in government bond markets.

The bubble is most likely to be burst by the very success of these QE programmes. They are designed to raise the rate of nominal growth in the economy, which to date has not occurred, and if that happens then investors will once again demand higher and positive yields than are available today. The scope for losing money in safe government bonds will then become manifest. As an example the UK Treasury 4% of 2060 was issued in late 2009 at a price of £96.25%, in October 2015 was trading at £136.65% and last week traded at £195.57%. Investors who bought it last week would receive an income yield of just over 2% and know that the bond would be redeemed in 2060 at a price of £100%, losing 95 points of capital value over 44 years.

As each bubble in risky assets in this century has burst, investors have flocked to their safe asset, government bonds. This is the asset class that has not disappointed since interest rates peaked under Paul Volcker in the US in 1981 – this 35 year bull market has delivered extraordinary returns for relatively little risk. The future will not, though, be the same as the past – instead government bonds will increasingly offer return-free risk. When this reversal occurs investors will need to unlearn the lessons of the last 35 years in markets and deal with a new reality – a return to inflation, rising yields and falling government bond prices.

From Heroes to Zeroes – 21st Century Central Banking

At the beginning of this century, the reputation of Central Banks in the West was at its apogee – over the previous 20 years inflation had been wrung out of the global economy by maintaining interest rates consistently higher than the rate of inflation. If inflation threatened to rise too sharply then raising rates by a few hundred basis points was sufficient to choke off consumer demand (since their mortgage repayments formed such a significant part of their disposable income) and slow the economy and inflationary pressures. Once this had been achieved, often requiring a quick recession, rates could be cut again and the restoking of consumer demand would reignite the economy. In short, it was apparent that Central Banking that had as its main target the control of inflation could be successful at only a small cost to growth. Politicians found themselves able to give up their desire to control interest rates for electoral purposes and give independence to their Central Banks. Central Bankers became Heroes!

The recession in the US following the bursting of the internet bubble and fears for the US economy following 9/11 however, saw the Fed cut US rates right down to 1% in 2002 and hold them there until 2004. 1% interest rates were much lower than seen in previous cycles and in hindsight were responsible for a massive inflation of the US housing market. Whilst the internet bubble was essentially financed by equity, since the new companies had no cash flow, the housing bubble was financed by debt. Debt-financed bubbles we now know inflate far further than equity-financed bubbles and then burst in a far more devastating fashion. Central Banks meanwhile, focussing only on the Consumer Price Inflation targets did not spot the bubble in the debt markets and so did not increase interest rates sufficiently to manage things better.

Following the 2008 meltdown in the global financial system and subsequent recession, Central Banks found that even interest rates that were effectively set at zero no longer helped to boost consumer demand. This was for two reasons, first consumers realised that they had already got too much debt and no longer wished to borrow more, even with low interest rates and secondly the all economic agents (banks, companies and consumers) had lost confidence in the future growth prospects of the economy that they did not want to lend, borrow or spend.

The Central Banks went back to their old textbooks to search for policy tools when interest rates can no longer be reduced and discovered Quantitative Easing (QE) which pushes money into the financial system in an effort to boost the demand for financial assets and thus stimulate the real economy. Many Zeroes of dollars, euros, yen and pounds have been created in this way. QE has almost certainly worked in the sense that economic growth in 2009, 2010 and 2011 would have been much worse without this policy, but it has not been enough to boost growth back onto a sustainable path. Worse still, repeated applications of QE seem to be less effective at doing this than the first effort. The scale of these interventions has brought forth much criticism of Central Banks in the US and the UK for creating the risks of hyperinflation from the creation of so much money. In Europe where monetary orthodoxy of the Bundesbank is enshrined in the ECB’s mandate, the Central Bank is criticised (outside Germany) for not doing enough to support the Eurozone economy.

For politicians, who are policy-constrained by huge fiscal deficits and debts, the only hope is that Central Banks solve their problems, but whilst Central Banks have the tools for fighting inflation, they do not have the tools for fighting deflation. They have done what they can (zero interest rates and QE) but have little more to offer bar providing liquidity to keep troubled banks alive and adding more zeroes to the money supply. The Age of the Heroic Central Banker is now behind us.