Market volatility has picked up and investors are jittery again. They’ve been spooked by yet more tariffs from the US and the US Fed refusing to surrender completely to the equity bulls.
Quite how any of us can be surprised by this stuff is beyond me. Trump is clearly engaged in the Art of the Deal and is going to push as hard as he can against the Chinese, so the tariffs stuff is really to be expected. And if I were the US Fed, I’d also keep my powder dry for now, and kick equity investors in the shins a little bit. They’ve become much too cocky about a cascade of interest rate cuts.
None of these recent developments should blind us to a deeper fact though. We are still mired in a low rate for longer environment where growth is sluggish outside of the US. Crucially the twin forces of globalisation and technology adaption are still having a huge deflationary impact. The first chart below is from the recent SPDR ETFs Bond Compass report for quarter three. It is I think an amazing sight to see. Here we are mid-way through a consistent economic pick up in the world’s largest economy and inflation rates are still trending downwards. If the US does slip into recession then we could see an even more dramatic decline in inflation rates, dragging even the US into deflation territory. Cue even gloomier forecasts from Albert Edwards at SocGen.
Which leaves me slightly perplexed as to what bond investors might be betting on at the moment. Some clues come from that SPDR ETFs report which observes that the biggest shift in behaviour has been investor behaviour occurred toward US Treasuries, “where overall demand collapsed, driven primarily by selling in the intermediate part of the curve…investors are not fully convinced that the Fed is about to embark on a protracted easing cycle against what is still a robust growth outlook.” Clearly these bond investors aren’t entirely dumb.
By contrast SPDR reports that fundamentals are more supportive for eurozone bonds, “where weaker growth and inflation expectations are fostering hopes of a re-start of QE. In response, demand for eurozone bonds has surged, notably into countries like Italy where investor holdings are still underweight. Gilts, meanwhile, have been left behind a little, and it is questionable how resilient they would be in a no-deal Brexit scenario.”
The SPDR report does though suggest an interesting contrarian investing idea, which is that inflation might make a comeback in the US. They observe that core prices “did surprise to the upside at the end of June, at 1.6% versus 1.5%. Nevertheless, that figure was low enough to reinforce the Fed case for a rate cut in July — and further if necessary. Should the dollar weaken as the Fed delivers on market expectations (as of end-June, the market expected more than 100 bps of cuts in 12 months), and if the Fed cuts more than the current dot plots, inflation could surprise to the upside. “.
I can see the logic, but I wouldn’t hold my breath.
In Europe by contrast, analysts at DWS have spotted a rather more elegant trade idea. How does anyone in Europe make money consistently when many government bond yields are in negative territory? One way to make some money is to buy “a German sovereign bond and holding it for just one year, instead of keeping it until maturity. In 12 months, a 10-year bond that currently yields -0.40% will turn into a 9-year bond. The latter trade at -0.49%, meaning that one can achieve a price gain on the sale that would overcompensate for the negative yield.”
Sounds intriguing but does it actually work in practice? Cue data from Japan. “On average, 10-year bonds have since traded at a meagre yield of just 0.011%. However, according to ICE Data Services, the average annual performance of indices tracking 7- to 10-year Japanese government bonds was +0.46% since February 2016. Japan proves that strategies exploiting the steepness of the yield curve have also worked in practice”.
All trades require someone to be on the wrong end of a strategy. Who’s paying for this investment lunacy? DWS suggests its “Investors who hold short-dated bonds have to digest price declines in addition to negative returns.