Back in 1982, the consensus among economists was that inflation and bond yields would remain high. They were wrong. Now the consensus is that inflation and bond yields will remain low (bordering on non-existent). Why should we have any more confidence in this projection than the earlier one?
It is quite extraordinary what has happened over the last 34 years. If you had been sufficiently courageous to suggest (back then) that nominal government bond yields would hit zero and even turn negative in several countries, you would have been shipped off to the nearest asylum for the clinically confused and bewildered.
In early September, some really crazy stuff happened — both Sanofi (French pharmaceutical company) and Henkel (German consumer goods group) sold 3½- and 2-year bonds with negative yields to maturity. The sales totaled €1.5 billion ($US1.63 billion). In layman’s terms, these companies are being paid to borrow. Now, this is a game we could enjoy. In fact, your correspondent is prepared to borrow a modest $10 million for three years with a cast-iron guarantee that the lender will be repaid $9.9 million. Please form an orderly queue.
Given the above, it was a little surprising to find that halfway through September there emerged a sudden consensus that the multi-decade decline in bond yields was over and that long-bonds would start to generate capital losses as yields gradually rose. In Germany, the negative 10-year yield moved into marginal positive territory while in Japan, the negative also became positive before lapsing back to slightly negative. Long-yields virtually everywhere saw an increase.
In the meantime, the U.S. Federal Reserve has declined the latest opportunity to raise official rates but has opined that it still may do so before the end of the year while the Bank of Japan has decided that it now needs to target the yield curve (after trying everything else) by attempting to lift long-yields relative to short (although it is not targeting any more than zero for long-yields!). It has maintained its policy rate at negative 0.1% and an annual target of 80 trillion yen (approx. US$800 billion) of bond and ETF purchases. It has also maintained a target inflation rate of 2%.
The BOJ now owns approximately 40% of the Japanese bond market. Its policies have helped destroy the viability of pension funds, remove hope from the country’s legion of aging savers and dramatically squeeze the profitability of banks and insurance companies. In addition to “playing” in the bond market, it has been injecting funds into the share market leaving it a top-10 shareholder in 90% of Japanese public companies. Just extraordinary.
Have the BOJ policies had any beneficial impact? Well, Japanese GDP and labor productivity growth remain anemic, inflation has slumped back to below zero and real wages have been on a steady decline for 20 years. Hardly a 10 out of 10 rating.
Our oft-expressed concern is that all of this extravagant interference by the world’s central banks in the operation of the market system has done more harm than good. Certainly, the stock market has risen based on the powerful jets of QE and lower interest rates but there is much that is wrong with the world economy. More and more debt has been piled onto the existing debt mountain but the marginal return from each extra dollar of leverage has steadily declined. If the “big” were too big to fail prior to the financial crisis, they are even bigger now. Central banks are flailing about but their understanding of how an economy functions demonstrates no greater degree of deftness than your average dart-throwing giraffe.
How this can end happily is something that we cannot prophesy. If support is withdrawn, will everything collapse? If support is not withdrawn, will everything still collapse?
As far as long-bond yields are concerned, we are prepared to stick our necks out. We do believe the game is over. Zero is zero, and zero is nonsense. It may still take a while but we believe that long-bonds are one of the greatest shorts that we have seen in our investing lifetime.