What will the end of the 30-year bull market in government bonds mean for other asset classes? That is where we left off yesterday’s holiday-shortened version of the Markets and Money. We take up the subject again today. But first a quick look at a market that has become simply irresistible. Yes, we’re talking about interest rates.
It’s becoming a bit of an obsession we admit. Interest rates are the last thing we look at before bed and the first thing we look at in the morning (even before coffee). They have made for compelling viewing in the last month. And oh what a story they are telling about the decline of Empire and the rise of…something else.
For a change, it was not just ten-year U.S. bond yields rising on Monday, although they were up to 3.89% as bond prices fell. Even the little old two-year notes are facing rising yields. The yield on the two-year U.S. note rose 11% to 1.42%.
These little cracks in the bond market are like the first small fractures in a plate glass window. Investors have a look at large government deficits everywhere and the fracture gets deeper and wider and leads to other cracks.
Central banks begin quantitative easing policies to buy up debt (some corporate, some mortgage-backed, and some which is their own cooking) and then you see the whole window blossom into rivers and rivulets of cracks, both beautiful and highly unstable at the same time.
And then someone comes along with a hammer, taps the pane gently, and the whole thing shatters like so much glass.
Of course, long-term bear markets in an asset class don’t always happen so suddenly. They begin with a reversal (which rising yields indicate), and then they fight conventional wisdom, losing an occasional battle. Today, for example, the U.S. dollar managed to rally a bit, while gold and oil fell.
But we think the early votes are in on the new trend in the market: sell bonds and buy commodities. It’s an inflation preparation strategy.
And why inflation? The proposed global deficits to combat the recession and the sickly credit markets are simply too large to be funded by private investors. “It is obvious that the Chinese and other surplus nations cannot fund the [U.S.] deficit even if they were fully on board — which they are not. Someone else has got to write checks for up to $1.5 trillion additional Treasury notes and bond,” writes Pimco’s Bill Gross.
“The concern is that this can be accomplished in only two ways — both of which have serious consequences for U.S. and global financial markets. The first and most recent development is the steepening of the U.S. Treasury yield curve and the rise of intermediate and long-term bond yields. While the Treasury can easily afford the higher interest expense in the short term, the pressure it puts on mortgage and corporate rates represents a serious threat to the fragile ‘green shoots’ recovery now under way.”
“Secondly, the buyer of last resort in recent months has become the Federal Reserve, with its publicly announced and near-daily purchases of Treasuries and agencies at a $400 billion annual rate. That in combination with a buy ticket for over $1 trillion of agency mortgages has been the primary reason why capital markets — both corporate bonds and stocks — are behaving so well. But the Fed must tread carefully here. These purchases result in an expansion of the Fed’s balance sheet, which ultimately could have inflationary implications. In turn, nervous holders of dollar obligations are beginning to look for diversification in other currencies, selling Treasury bonds in the process.”
Gross finishes with this advice: “Bond investors should, therefore, confine maturities to the front end of yield curves, where continuing low yields and downside price protection is more probable. Holders of dollars should diversify their own baskets before central banks and sovereign wealth funds ultimately do the same. All investors should expect considerably lower rates of return than what they grew accustomed to only a few years ago.”
Got that? Be in short term bonds. Sell the dollar. Own commodity-based currencies (actually Gross doesn’t say that, but we do!). And reduce your expectations for total returns. Not very cheerful, is it?
Gross may be underestimating the amount of money punters can make in small resource exploration shares. That’s probably because he manages billions of dollars. That keeps him in the fixed income market. He is too big a player to have a punt in small Aussie resource shares.
But we know that inflation fuelled rallies benefit smaller commodity stocks the most. And fortunately, there is no shortage of investment ideas or speculative bets in Australia. If you had to live in a world where investment returns were expected to be lower for awhile, you’d want to be in the one market where the returns on offer are still pretty double-digit looking. That’s Australia.
Whether those returns materialise will depend on our good friend China. And according to some reports this weekend from China’s official Xinhua news agency, Australia had better send flowers to Beijing soon, or at least chocolate. And probably an apologetic text message over this whole Rio business. A teddy bear wouldn’t hurt either. With a big red bow.
for Markets and Money