As Jim Reid writes, “it’s been a very dull 24 hours” in the markets, so to pass the time the Deutsche strategist recapped his bigger picture thoughts “on government bond yields given the sell-off of the last two weeks.” Hardly surprising, he goes along with the consesus, and expects yields to rise as more central banks turn hawkish (for reasons we have discussed on countless occasions, most recently yesterday) although what is interesting is Reid’s take on what happens after the initial reaction, and it’s here that the gloom descends because in a world with 327% debt/GDP…
… higher interest rates are simply unsustainable, the endgame is one: “at some point a government spends big and yields start to rise faster. This could still be many quarters ahead but if and when it does happen central banks might have to intervene and cap nominal yields to avoid carnage in a heavily indebted world. Then we move towards helicopter money…”
For now goldilocks remains, at least until one or more risk-parity fund gets whacked, and the momentum-chasing, vol-selling deleveraging begins.
His full note below:
After a very dull 24 hours I thought it might be an opportune moment to recap our bigger picture thoughts on government bond yields given the sell-off of the last two weeks. As we discussed in our Long-Term Study last September we think 2016 will likely be seen as the inflection point and the end of the 35 year bull market for bonds. It won’t be a straight line reversal and perhaps the issue will eventually be more for future real returns over nominal returns. The reason for picking out 2016 was that this was the year that 1) voters in the bottom half of the income scale effectively won two landmark national votes and 2) endless extreme monetary policy for the first time started to impact the plumbing of the financial system. The impact of the first point is that it likely means politicians now have to steer policy specifically to this poorer income group to ensure that their electoral chances are enhanced. This likely means more fiscal policy and less austerity. The recent UK election reinforces this theme here and we think the theme will slowly spread.
With regards to the second point, 2016 was the year that negative rates cascaded like wildfire along the government bond curve in Europe. The problem being that the correlation between falling yields and poor EU bank equity performance is very strong and the correlation between bank equity and bank lending suggests that had the trends of 2016 continued much further then the real economy could have actually suffered by the negative yields actually aimed to support growth.
However the fact that the BoJ and ECB pulled back from full-on QE in the last 4 months of last year suggested they appreciated that monetary policy had perhaps gone too far for now and was having some negative consequences. As such a slow reversal of the ultra low yield environment should have and should continue to follow.
The risk being that at some point a government spends big and yields start to rise faster. This could still be many quarters ahead but if and when it does happen central banks might have to intervene and cap nominal yields to avoid carnage in a heavily indebted world. Then we move towards helicopter money – a story for another day.
The problem with this view is that it’s as much to do with gut feel, a change in the political wind, and second guessing policy makers as it is to do with spreadsheet based analysis of the current available facts. As such it makes it much more difficult to prove! Anyway this is likely to be a slow moving story for now but generally since last year we’ve thought the general bias on yields is higher.