Bond markets are behaving most oddly

Over the weekend, I read a very troubling article about the appearance of Chinese-sourced synthetic drugs, some newfangled sort of opioids, that are supposed to be multiple times stronger than heroin, and which are taking hold around the world. Should we fear that this is what US equities are on as the Dow Jones Industrial Index on Friday carved through 40,000 pts to close at a new all-time record high? Maybe but I am not as concerned about equities which I do not purport to understand as I am about the global interest rate complex which is also on its own fanciful mission. I have watched bond markets for well over 40 years and I have never been quite as confused as I am now.

I think it might have been a Bloomberg article that got me going as it was jumping up and down celebrating the ongoing rally in bonds. I’m sure everybody loves a rally although I shall never forget the words of one of my erstwhile German clients who, when I called one morning and commented on how good markets were doing, laconically replied: “Mr Peters, whether markets are good or not depends on whether you have money invested or money to invest”. A good market is one that is correctly priced for the circumstances, a simple truism that has remained with me ever since and one which I tried to instil in the many mentees I attempted to train in the four-dimensional chess game of understanding bonds.

A rally in the price of any class of asset, if it cannot be solidly justified, does nothing other than to increase the embedded risk. And I’m afraid that is how I currently feel about 10-year US Treasuries at 4.41 per cent, 10 year Gilts at 4.12 per cent and, to a similar but lesser extent, about the eurozone benchmark 10 year German Bund at 2.52 per cent.

In his daily missive on Friday, my dear old friend Alex Moffatt of Joseph Palmer & Sons in Melbourne, a highly skilled bond trader – the only one with whom I have worked and who I never once heard utter an oath on the trading floor – who then went to the dark side to become a wealth manager, wrote, “There is a growing chorus of voices expressing concern at the ever-growing pile of debt the US government is accumulating; those voices include the CEOs of JP Morgan and Bridgewater. Separately, the European Central Bank has sounded the alarm over increasing debt levels amongst European member states. At the conclusion of a financial year, a nation’s budget deficit – that is the difference between what it receives in taxes and what it spends – simply goes into the national debt pile. The national debt is funded by borrowing money in the capital markets either domestically or internationally and the interest payable on that debt forms a part of the annual budget expenses. Naturally, as interest rates rise, so the expense of carrying and maintaining a large indebtedness also increases.”

So why are financial writers jumping up and down when yields fall rather than raising a warning flag? Governments, ahead of all that of the United States, are borrowing prodigious sums of money, unprecedented ones, and instead of charging a higher rate of interest for pleasure, investors are not only falling over themselves to lend it at lower rates but are apparently feeling good about it.

I was recently digging around to see how the Federal Reserve’s quantitative tightening programme was progressing. With that, I mean how much of the roughly US$4 trillion of Treasuries that it had bought and parked on its balance sheet had been passed back to the markets to finance. Who can’t forget the so-called  “taper tantrum” of 2013 which was marked by a surge in yields when the Fed had the temerity to suggest that it was preparing to slow the rate at which it was buying its own government’s debt. That was half a decade before the term quantitative tightening had even been coined but at the time markets were highly sensitive to Fed action and above all to the fact that central banks, the Fed included, had traditionally been directly involved in short-term money markets but that the price of anything with a maturity of longer than one year had in essence been set by good old market-driven supply and demand.

Former Fed Chairman, Alan Greenspan, had the often annoying habit of opining on whether he thought longer rates were appropriate or not – part of what is referred to as verbal intervention – but that was as far as he could go. The launch of QE, of “unconventional policy tools” as his successor Ben Bernanke euphemistically referred to it, brought the Fed right into the market and by choosing which bonds to buy when it was able to manipulate yield at all parts of the curve. The pretext was that it felt it could not leave price formation to conventional demand and supply as the objective was to keep long yields as low as possible in order to encourage long-term capital investment, even in the face of a struggling economy. The same applied to the post-GFC period as it did during Covid. QT, quantitative tightening, was to mark the reversal of QE and with it was to come the running down of the Fed’s balance sheet.

Please indulge me for constantly referring to the Fed. The same principles apply to the Bank of England and the ECB as it does to the non-eurozone Scandinavian central banks so I shall continue to look to the Fed as a valid pars pro toto.

In April 2022, the footings of the Fed’s balance sheet peaked at US$ 8.995 trillion. Prior to Lehman Brothers hitting the wall in September 2008, it had stood at US$ 995 billion. Then QE was triggered and a year later it was at US$ 2.2 trillion. On 19 June 2013, Chairman Bernanke announced that the Fed would begin to “taper”; that did not mean a reversal of QE but merely a slowing in the rate at which the Fed was strapping on debt, both in the form of Treasuries and mortgage-backed securities. In June 2013, the Fed’s balance sheet stood at an eye-watering US$ 3.3 trillion. Far from reversing policy, the Fed continued to buy bonds up to a level of US$ 4.5 trillion and from the summer of 2014 onwards began to very, very gently reduce its holding. By September 2019, its balance sheet had been reduced to US$ 3.7 trillion. Then Covid hit, the bond buying was resumed so that by April 2022, the balance sheet had swelled to over US$ 8.9 trillion. At this point, roughly a quarter of the entire US national debt was owned by the Fed. Now this debt is being handed back to the markets.

I have read some completely serious research that has suggested that all the Fed has to do is to let the bonds it owns mature and then that’s it. I’m sure there are many people who wish that, when the fixed term of their mortgage comes up, banks could simply say “It’s run off; thank you and you’re done.”. Nope, it needs to be refinanced by somebody else and if the Fed isn’t doing it, it’ll have to be the markets. As of last week – the last reported figures are from 15 May – the Fed’s balance sheet has shrunk to US$ 7.3 trillion. That’s still US$ 4 trillion more than when the Taper Tantrum occurred but it is also US$ 2.6 trillion less than in June 2022, just over two years ago.

And now for the conundrum. Government borrowing is going through the roof, now without the Fed doing the heavy lifting, while at the same time it is adding to the burden by not refinancing what it had owned to the tune of over US$ 1 trillion a year. Sure, government bond yields have risen sharply since mid-2022 and in line with central bank rates. But yield curves not only remain inverted, yields are falling. There is something that simply doesn’t add up.

I am not alone in my efforts to square the circle. So far, and please excuse the grumpy old man explanation, the closest I have come to an understanding when sharing thoughts with some of my equally superannuated peers is that the markets are now populated by young men and women who don’t know that they should at this juncture be running for the hills. The expectation that the Fed and its friends and relations will, in the case of the ECB by June, begin to ease monetary policy by initially cutting interest rates is in our opinion not reason enough to buy the living daylights out of the rest of the bond market. A lower cost of money should reflect lower risk;  it appears as though lower rates are now doing the very opposite. As I wrote early last week, we don’t know when the next black swan will take to the air, but we do think that we have a pretty good idea of what it will look like when it does.

Driven by index tracking, institutional investors don’t need to care whether the market has got it right or wrong as long as they are on the right side of the move. Peters’ Second Law does after all hold that nobody has ever been fired for being long of a falling market but being short of a rising one is a career-threatening error. Never mind the quality, look at the price. Alex Moffatt refers to Jamie Dimon and Ray Dalio as warning of the risks of too much debt although they are not alone as Kristalina Georgieva, managing director of the IMF, is quite vocally singing from the same hymn sheet.
 
Ringing in my ears is that most annoying of choruses that went “Austerity doesn’t work”. Of course it doesn’t. When the government stops feeding the economy money it does not have it will slow. It’s not a quiz. Now name one democratic government, one that has to freely and fairly present itself to the electorate, that can survive the ignominy of having “engineered a recession through austerity”. In the early days of the pandemic, I noted – rather more presciently than I had expected – that today’s emergency support will become tomorrow’s entitlement. Governments are behaving as though all is well in the garden and for their sins markets appear to be believing them. That said, if longer-term government debt were priced commensurate to the actual risks, then interest payments alone would more or less bankrupt our nations.

We’re in a mess but as long as we can match or even outperform our benchmarks, who cares? The Dow’s above 40,000 pts and bitcoin is at US$ 66,500 so what can there be to worry about? The Nasdaq is up 11.16 per cent year to date while Kathie Wood’s ARKK Innovation ETF is down by 13.31 per cent; who said there’s nothing left that one can rely on? Oh, I forget that she’s doing it so that investors can take advantage of a great buying opportunity….

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