Tuesday, March 17, 2015

How Scary Is the Bond Market?

Nobel laureate Robert Shiller, Professor of Economics at Yale University and the co-creator of the Case-Shiller Index of US house prices, wrote a comment for Project Syndicate, How Scary Is the Bond Market?:
The prices of long-term government bonds have been running very high in recent years (that is, their yields have been very low). In the United States, the 30-year Treasury bond yield reached a record low (since the Federal Reserve series began in 1972) of 2.25% on January 30. The yield on the United Kingdom's 30-year government bond fell to 2.04% on the same day. The Japanese 20-year government bond yielded just 0.87% on January 20.

All of these yields have since moved slightly higher, but they remain exceptionally low. It seems puzzling – and unsustainable – that people would tie up their money for 20 or 30 years to earn little or nothing more than these central banks' 2% target rate for annual inflation. So, with the bond market appearing ripe for a dramatic correction, many are wondering whether a crash could drag down markets for other long-term assets, such as housing and equities.

It is a question that I am repeatedly asked at seminars and conferences. After all, participants in the housing and equity markets set prices with a view to prices in the bond market, so contagion from one long-term market to another seems like a real possibility.

I have been thinking about the bond market for a long time. In fact, the long-term bond market was the subject of my 1972 PhD dissertation and my first-ever academic publication the following year, co-authored with my academic adviser, Franco Modigliani. Our work with data for the years 1952-1971 showed that the long-term bond market back then was pretty easy to describe. Long-term interest rates on any given date could be explained quite well as a certain weighted average of the last 18 quarters of inflation and the last 18 quarters of short-term real interest rates. When either inflation or short-term real interest rates went up, long-term rates rose. When either fell, so did long-term rates.

We now have more than 40 years of additional data, so I took a look to see if our theory still predicts well. It turns out that our estimates then, if applied to subsequent data, predicted long-term rates extremely well for the 20 years after we published; but then, in the mid-1990s, our theory started to overpredict. According to our model, long-term rates in the US should be even lower than they are now, because both inflation and short-term real interest rates are practically zero or negative. Even taking into account the impact of quantitative easing since 2008, long-term rates are higher than expected.

But the explanation that we developed so long ago still fits well enough to encourage the belief that we will not see a crash in the bond market unless central banks tighten monetary policy very sharply (by hiking short-term interest rates) or there is a major spike in inflation.

Bond-market crashes have actually been relatively rare and mild. In the US, the biggest one-year drop in the Global Financial Data extension of Moody's monthly total return index for 30-year corporate bonds (going back to 1857) was 12.5% in the 12 months ending in February 1980. Compare that to the stock market: According to the GFD monthly S&P 500 total return index, an annual loss of 67.8% occurred in the year ending in May 1932, during the Great Depression, and one-year losses have exceeded 12.5% in 23 separate episodes since 1900.

It is also worth noting what kind of event is needed to produce a 12.5% crash in the long-term bond market. The one-year drop in February 1980 came immediately after Paul Volcker took the helm of the Federal Reserve in 1979. A 1979 Gallup Poll had shown that 62% of Americans regarded inflation as the “most important problem facing the nation." Volcker took radical steps to deal with it, hiking short-term interest rates so high that he created a major recession. He also created enemies (and even faced death threats). People wondered whether he would get away with it politically, or be impeached.

Regarding the stock market and the housing market, there may well be a major downward correction someday. But it probably will have little to do with a bond-market crash. That was the case with the biggest US stock-market corrections of the last century (after 1907, 1929, 1973, 2000, and 2007) and the biggest US housing-market corrections of all time (after 1979, 1989, and 2006).

It is true that extraordinarily low long-term bond yields put us outside the range of historical experience. But so would a scenario in which a sudden bond-market crash drags down prices of stocks and housing. When an event has never occurred, it cannot be predicted with any semblance of confidence.
I happen to agree with Shiller, there will be a major downward correction in the stock market and housing market but it will have little to do with a bond-market crash. To understand why this is the case, you have to understand the titanic battle over deflation which central banks are all fighting around the world. 

Importantly, deflation remains the biggest threat to the global economy. Aging demographics, a global jobs crisis, high public and private debt, a looming retirement crisis and rising inequality are all deflationary factors weighing on global consumption.

Nonetheless, the demand for long-term debt by global investors is cooling off. An astute hedge fund manager shared this with me on Monday:
We regularly track trends in asset allocation by the Norwegian Oil Fund as proxy for the behavior of sovereign wealth funds. The Norges Bank published its full report for 2014 this week. In a continuation of the trend we noted last December, the Norges Bank continued to buy equities in Q4 last year close to $50bn the biggest quarterly buying ever. In addition, they bought around $25bn of bonds and $8bn in real estate, a historical high for real estate.

Overall the Norges Bank stepped up its buying of equities last year by buying $70bn of equities during 2014 (vs. $18bn in 2013, a 288% increase) and reduced its pace of buying bonds from $66bn in 2013 to $33bn in 2014.
But while Norway's mighty sovereign wealth fund is stepping up its purchases of stocks and real estate and cooling its purchases of bonds, as are most other global pensions and sovereign wealth funds, the truth is there is a thirst for long-term bonds by many large corporations looking to de-risk their pensions and shift out of defined-benefit plans.

Unlike public pensions and sovereign wealth funds, private corporations simply can't afford to take on longevity risk and risk being decimated by deflation. This is why I long argued that defined-benefit pensions should be treated as a public good, reformed to introduce world class governance and shared-risk, and backstopped by the full faith and credit of the federal government.

Anyways, getting back to the U.S. bond market. I've long argued against bond bears, including smart guys like Leo de Bever and Michael Sabia. They simply got their bond calls wrong because they underestimated the deflationary forces wreaking havoc on the global economy.

To be fair, they weren't alone. The only large pension that got its bond allocation right is HOOPP, which delivered outstanding results in 2014 investing in long dated U.S. bonds. And I got news for you, HOOPP will keep trouncing its larger peers in Canada and elsewhere as long as global deflation remains a lingering risk.

Another reason why I don't see a bond market crash is that the global carry trade is alive and well. To be sure, this poses serious risks to the bond market if it unwinds violently, but the reality is global investors are all clamoring to buy U.S. bonds for two reasons: yield/growth prospects and flight to quality.

If you look around the world, there isn't much growth going on outside the U.S. and even within the U.S., we can have a serious debate as to the quality of growth going on there. This is why I still maintain that if the Fed raises rates in June or August, it will be making a monumental mistake.

Having said this, the consensus believes the Fed is behind the curve and will raise rates this summer and global investors are slashing their exposure to U.S. stocks on rate hike fears. Even well-known bond bulls like my friend, Brian Romanchuk, have pointed out the risks of underestimating rate hikes in this environment.

Still, I agree with those that argue market expectations of a first Fed rate hike are unrealistic. The Fed and other central banks are worried about global deflation and that's why they're fighting tooth and nail to prevent it (it's a losing battle but enjoy the liquidity party while it lasts).

Below, CNBC's Steve Liesman reports more than half the respondents to CNBC's exclusive survey think the Fed is too accommodative. That just shows me most investors are on the wrong side of the trade and are severely underestimating the risks of global deflation.

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