The Financial Times nailed it this morning with its headline article titled “Bank of England bond-buying programme hits trouble”. Being the grumpy old git that I am, I am prone to believing that the trouble really began when the original plan was hatched although the Pink’un, not unreasonably, is looking at the issue from a different angle.
The newspaper reports that the Old Lady had yesterday gone into the market with intention of buying, under its ongoing quantitative easing programme, £1.17bn of long-dated gilts but it only secured offers to sell of £1.12bn. The glass-half-full brigade would argue that missing on £50m is next to nothing and that August liquidity – or lack thereof – is the reason. Glass-half-empty merchants will hold up the shortfall as proof that investors have no intention of shelling out their rare long-dated fixed income assets for a quick turn, especially when they know that they won’t stand a snowball in hell’s chance of ever replacing them.
We are, and have been for some time, in a battle for the heart and soul of the bond markets. Fixed income assets are held by investors for two main reasons and no Olympic gold medals for guessing which ones these are. Firstly it is for the income and secondly because that income is fixed. Bonds are supposed to be the anchor, the safe haven of every investment portfolio.
I have frequently struggled when I have read, as I have repeatedly in the past few years, that bonds have been the best performing asset class. Bonds aren’t here to perform, they’re here to gently tick away in the background clocking up predictable cash flows from which the asset managers’ or investment managers’ liabilities can be met. The yield on an individual bond tells us nothing; it is the bond’s yield relative to all other bonds in a comparable maturity and credit risk space that is relevant.
The price of an equity asset rises, theoretically at least, when the prospect for increased earnings and rising dividends takes hold. Bond prices rise when the prospect is for lower and not higher future income. I used to cover a portfolio manager at the Swiss head office of Zurich Insurance. Peter Mueller, long ago retired, and who appeared to suffer from mild OCD - those who knew him will also know what I mean - was also a bit of a horror to unprepared bond jockeys. To the greeting “Good morning, how are you?” he’d routinely answer “No need to ask me that….I’ll tell you if I’m not well”. In the same vein if one ventured to comment in a strong market environment “the markets are looking good today” he’d come back, quite rightly, with “That depends on whether one is invested or whether one has money to invest”. That makes total sense but is not a sentiment which can be reflected in the algorithms that calculate the total return of bonds.
When 30-year gilt yields are at 1.38%, let alone 30-year French OATs at 0.89% or German Bunds at 0.39%, there is nothing exciting about a further rally in prices brought on by central bank activity in what is supposed to be an open market.
Pension funds have a need to generate income from which to meet their liabilities and although capital gains are part of their total return, they don’t really meet the need. Having to sell assets to make up the shortfall costs bid/ask spreads, which are rising in progressively more illiquid markets and wipe out most of the already paltry coupon income. Replacing coupons with dividends might offer a quick fix but this is not the object of the game and in a post-financial crisis environment where risk is supposed to be cautiously managed, pushing investment capital into equity markets is not the way.
Law on risk
Regular followers of my thinking will know Peters’ First Law on Risk, which states that market risk is like energy; it can be converted but it can’t be destroyed. The Second Law states that in markets money is never lost; it just belongs to somebody else. Selling gilts at these levels to the Bank of England is tantamount to presenting the Old Lady with a huge free-of-charge put option, having acquired it at equally no cost and entirely without his knowledge from Jonny Retail.
Equity investors, meanwhile, are suffering from a double deception. The first one is that all calculations on discounted future cash-flows are being carried out over a synthetically low yield curve and secondly, the paltry income stream being generated by bonds, issued by both governments and corporates, is pushing more and more money into equity markets and for entirely the wrong reasons. No wonder the Likes of Bill Gross and Jeff Gundlach suggest that selling everything is the right way to go. On a fundamental risk/return basis they are absolutely right but until the central banks drop the ball, which they are loath to do, the merry-go-round won’t stop.
Do I hate both bond and stock markets at these levels? Sure I do. Is it time to sell them? I think not. As I observed a few days ago, we’re playing a game of 4D chess where the fourth dimension is the randomness of central bank intervention. Generous total return figures for bond markets might satisfy short-term needs but they are setting us up for some rude shocks and hard knocks although when that will happen is anybody’s guess. In other words, I’d not be at all tempted to give the Bank of England any bonds I held; how the hell and at what price will I be able to replace them? Answers on a “sell” ticket please. Index jockeys probably don’t even know how to spell “running yield”.
Meanwhile, back in the rest of the world, I read that the Greek parliament has so far approved a mere 38% of the agreed reforms and that only 13% of the reforms have been implemented. How very stupid of me to have forgotten that this time it is different. At least Great Britain can hope that its Brexit settlement, whatever that might look like, will be implemented with the same ruthless rigour as have been the conditions for Greece’s repeated and on-going bailouts.
Is it really only Wednesday?