The Greatest Bubble on Earth
For the
majority of investors the financial market of choice is the Stock Market, be it
the Dow Jones Industrial Average, the FTSE 100 or the NZX50 there is an index
of stocks near you that offers the opportunity to invest and get a return on
your money. However
although global stock markets are big, they are dwarfed by the scale of the
market in global bonds.
According to an August 2011 report by Mckinsey & Co the value of
global stock markets were put at $54 trillion, by comparison global bond
markets were valued at $157 trillion, almost three times the size. Of this $157
trillion the US
debt market accounts for $37 trillion or about 24%, making it the single most
important market when it comes to investment.
The
reason that bond markets the world over fly beneath the radar of the majority
of investors is mainly because they are more difficult to understand, but
whilst it is certainly the case that you do need a greater depth of financial
knowledge to navigate the world of bonds safely, you do not need to be a
genius, a little bit of thought and application will do the trick. There
is however an old saying that goes ‘There is only one difference between the people
that work in bonds, and those that work in equities – it’s called a brain’, now
having worked in equities for almost thirty years I have some issue with that
statement, but I will admit that there is more than a grain of truth in it!
So why is
the bond market so large in comparison to equities when it is clear that the
majority of investors don’t understand it enough to invest in it? There are a couple of reasons, firstly because bonds are debt instruments they are the primary source of funding for governments and many corporates, with both of these entities prefering the certainty of borrowing at a fixed rate for a fixed duration. Because of the diversity of the issuing entities, their credit rating, the time till maturity of the bond and the interest rate available, the bond market overs a deep pool of liquidity to those investors looking for the benefit of a fixed rate of return. On the demand side of the equation, although the majority of investors (mainly individuals) don't understand the market enough to invest in it directly, this group only controls a small part of the total
pool of investment funds, the overwhelming majority of these funds are
controlled by institutions like pension funds, insurance companies and
financial institutions, and these organizations do understand how the market works (theoretically!).
These
institutions purchase bonds for a whole host of reasons including preserving
capital, earning a predictable return, ensuring they can meet future pension
liabilities, to buffer themselves from the effects of stock market volatility, to
act as a hedge against political uncertainty, and as a directional bet on
falling inflation to name just a few. Often it is a more mundane reason,
because the bigger the institution the fewer the options available to park its
money (under the mattress is not an option), and the massive liquidity
available in the bond market makes it an attractive option.
Since the
1980’s we have witnessed a huge secular bull market rally in global bonds, and
with the inverse relationship between a bond price and its interest rate (see http://www.investopedia.com/university/bonds/bonds3.asp
), we have seen interest rates falling in this period from the high double
digits down to the low single digits into the middle of last year. This huge rally
is just part of a much larger repeating cycle of economic boom to bust and back
again, first discovered by the Russian economist Nickolai Kondratiev and now
known as the Kondratiev cycle.
The cycle
itself can be broken down into four distinct phases, often labelled spring,
summer, autumn and winter. In the spring phase credit flows into the productive areas of the
economy, leading to a huge amount of economic activity bringing growth and
prosperity (think 1950 – 1970), as the cycle wears on spring turns into summer
and this explosive growth plateaus, leading to a reduction of investment opportunities and as a result the credit heads towards
other areas resulting in general rising prices, rising commodity prices and
rising interest rates, and thereby setting the stage for the huge bond market rally
to follow during the autumn period.
It’s from this point of extremely bombed out bond prices
(and the corresponding high interest rates) that our current bond market rally
originated, and its that journey of falling interest rates over the last thirty
years that has powered the numerous other asset price booms that have occurred
over the same period.
Since the lows of 1981 the market has rallied
consistently, resulting in one of the longest winning streaks in the history of
investment. According to Merrill Lynch, long term bonds returned over 11% a
year through to 2011, and that is spectacular by any investment benchmark.
Over the last few years this trend has been accentuated
by the US Federal Reserve’s decision to skew the bond market with the use of
QE, in order to keep interest rates low. Through the various manifestations of
QE1,2 and 3, rates have been driven to multi decade lows in order to spur a sustainable recovery, but inspite of pumping billions of dollars into the system, it remains elusive.
The chart below shows us the path of US interest rates since the mid 1950s.
Looking
at this chart it is plain to see that rates can virtually go no lower, but
when the tide turns, and it always does, it suggest they can potentially go much higher.
We
got a preview of how ugly that might look when the Fed announced back on 19th June that it would begin
"tapering" some of its QE policies contingent upon continued positive
economic data, and that it would scale back its bond purchases from $85 billion
to $65 billion a month during the then upcoming September 2013 policy meeting.
It also suggested that the bond buying program could wrap up by mid-2014 and laid out the path by which it would likely start raising rates.
The effect was dramatic, with bonds plummeting and US interest rates jumping 0.80% in a few days (a 0.80% increase on a 1.70% interest rate is a big move in anyone's language), this reaction also bled out into equities with the Dow Jones dropping 659 points in the three days following the announcement.
Scared by the markets reaction to someone taking away the 'juice', the Fed proceeded to reassure the financial markets until their 18th September meeting, at which they announced they would be holding off from any tapering for the timebeing, triggering a short-lived relief rally in both equities and bonds.
This short episode, whilst slightly bizarre, has been informative as it has given us a taster of just how painful it will be when the bond market bubble finally pops.
So do we have any clues as to what might trigger it and when it will happen? On this point the Kondratiev cycle provides some guidance. When the credit fueled boom of autumn finally ends, it is replaced by the Kondratiev winter. During this period there is a credit crisis leading to a credit crunch and sharply rising interest rates, this squeezes the excesses (built up during the preceeding autumn phase) out of the system by bankruptcy and default until we are once again ready for the cycle to begin again (think 1930s depression -1950).
In our current situation, most of the debt is held by sovereign states, meaning that it is the debt of countries that will come under the most pressure as investors increasingly come to realise that holding sovereign debt is no longer a safe investment. This is already starting to happen.
In terms of when will it start, the answer is it already has. We saw the lows in US interest rates back in mid 2012, since then they have been rising despite the best efforts of the Fed. I can already hear some people saying 'that's just an American problem, it won't happen here', unfortunately I don't share their optimism. Because of the long held belief that the US is the safest of safe havens, the US Treasury bond market is the benchmark against which all other investments are measured and as a result where US interest rates go, sooner or later so do our own. It will be impossible for any country to insulate itself from the effects of a collapsing US bond market, it is just an unpleasant flipside of globalization.
Currently the financial markets are wrestling with the potential fallout from a failure to resolve the US budget issue and the pending debt ceiling debacle. I think there will be a lot more politicking before we see a resolution (ie kick the can down the road!) and we will likely see global stockmarkets and the US dollar turn weaker before there is enough pressure on politicians to come to an agreement. Once this correction has run its course I believe we will see some dominant trends emerge. As the Kondratiev winter starts to bite, the bond bubble will finally burst, starting in the weakest economies first. Money will increasingly flow from these economies into the US looking for yield and a safe haven, unfortunately we now know that the old standby of the US bond market isn't as safe as it used to be, offers virtually no return on your money and is at the end of a thirty year rally, and as a consequence this money will go to the only game left in town, the stock market.
This promises to be a very scary ride, the long US treasury bond trade is very crowded indeed (by definition it always is at bubble tops), and when everyone heads for the exits at the same time it will get messy. But this time, unlike stock market bubbles that are painful but not terminal, the effects will be far more profound and far-reaching, with the potential to impact all our lives no matter where we live.
The Bond markets have been a great ride for 30 years but now is the time to get off this particular gravy train.
Higher interest rates are coming to a town near you, protect yourself!
