April 20, 2015
[Editor’s note: This letter was penned by Tim Price, Director of Investment at PFP Wealth Management in the UK.]
In Lewis Carroll’s Through the Looking-Glass, the Queen would sometimes believe as many as six impossible things before breakfast.
She is probably working in the bond markets now.
The average yield on all German government debt is now less than zero, for example. This doesn’t really make any sense, but then not much does any more in the interest rate markets.
We saw last month that the Danish sex therapist (this detail being entirely gratuitous) Eva Christiansen had just been approved for a small business loan at a rate of minus 0.0172%. Ms. Christiansen is herself receiving interest on the loan she’s taken out.
At the same time Danish depositors are paying 0.5% for the ‘privilege’ of keeping their money in the bank.
There was once a time when unprecedented things happened only occasionally. In today’s financial markets, unprecedented things are commonplace.
Jamie Dimon, chairman and CEO of JP Morgan, points out that on October 15, 2014, the yield on US Treasury bonds moved, intra-day, by 40 basis points. How did he describe that move? “Unprecedented.”
But it matters, because Treasury bonds are meant to be the cornerstone of the capital market structure. If Treasury yields move up and down in a single day like a roller coaster, it does not suggest massive confidence in the rest of the financial system.
This pronounced volatility may be a precursor to larger shocks to come.
Even Mr. Dimon himself highlights this concern when he talks about much reduced liquidity in the bond market:
“[T]he total inventory of Treasuries readily available to market-makers today is $1.7 trillion, down from $2.7 trillion at its peak in 2007. Meanwhile, the Treasury market is $12.5 trillion; it was $4.4 trillion in 2007.
“The trend in dealer positions of corporate bonds is similar. Dealer positions in corporate securities are down by about 75% from their 2007 peak, while the amount of corporate bonds outstanding has grown by 50% since then.
This is an incredible reduction in liquidity in what’s supposed to be one of the most liquid markets in the world.
But what does it mean?
For context, it was dodgy corporate credit and mortgage backed securities (bonds) that imploded back in 2008. Suddenly there was no liquidity.
We heard a great line at an investment conference during the dark days of 2008 that summed it up:
“If you’re a distressed seller of an illiquid asset in a market panic, it’s worse than being trapped in a crowded theatre that’s on fire. It’s like being trapped in a crowded theatre that’s on fire, and the only way you can get out is by persuading someone on the outside to swap places with you.”
Given the liquidity dynamics highlighted by Jamie Dimon, all best are off in the bond market. Even the value of US Treasury securities can implode in an instant.
At the recent Grant’s Conference in New York, fund manager Paul Singer identified an even bigger short than the original Big Short (repackaged sub-prime tat). This new, even bigger short?
Long-term claims on paper money. In other words, all bonds.
Is it remotely possible that at some point, perhaps quite soon, the bond market could see yields spike higher, driven by…? As Paul Singer puts it,
“A surge of inflation which far exceeds the strength of the economies is not out of the question and could be catalyzed and accelerated by the oft-stated goal of central bankers to cause more of it.”
The bond market is acting schizophrenically. The cognitive dissonance is deafening.
It has pushed down the yields of bonds on the tacit understanding that central banks (most recently, the European Central Bank) will be buying them by the bucket-load.
But the expressed purpose of so-called Quantitative Easing is to ignite inflation. If you believe that central banks can succeed in creating inflation, then you should be selling bonds, not buying them, especially when they’re yielding less than zero.
We’re not convinced that central bank money creation can easily trigger inflation when the forces of deflation seem to be currently so powerful.
But it matters not. Anybody with half a brain cell will recognize the risk inherent in bond markets today. The relative and absolute attractiveness of undervalued equities, by comparison, is now astonishing.
The only people who should be buying bonds today are altruistic billionaire lunatics with a financial death wish.