Low interest rates will rise
Australian households have come to depend on low interest rates and operate as if it’s normal. While household debt in the US, Britain and Germany has fallen materially since the GFC, the reverse is true in Australia. Aussie battlers have leveraged up to chase asset prices higher, particularly property, increasing their debt to 185 per cent of disposable income, from 170 per cent since 2008.
As a nation, we are ill-prepared for any reversal of the global bond market rally that is now in its third decade. The inverse relationship between bond prices and yields means that as bond markets decline, long-term interest rates will inevitably rise.
Global sovereign 10-year bond rates have been in decline now for 30 years, but the declines over the most recent decade are not the result of the normal buying and selling activity by rational and sensible long-term investors.
The most recent declines in bond rates, particularly the move to negative interest rates for 30 per cent of the world’s sovereign bonds, is the work of central banks and has produced rates that no longer, even reasonably, reflect risk. When Italy can borrow money at negative rates despite non-performing loans in their banking system amounting to 25 per cent of GDP, the bond market has ceased properly signalling risk.
And yet these low rates are what professional investors use to inform the discount rates they use to value assets. And the greater the proportion of cheap debt a company has, compared to relatively more expensive equity, the lower the discount rate. So a company’s shares are more valuable because it has more debt!
Of course, all this will unwind and we will look back with astonishment that investors were, for example, willing to lend money to the Swiss government for 30 years just to receive 96 per cent of their capital back. Bond king Bill Gross has warned that the $US10 trillion pile of negative-yielding government bonds is a “supernova that will explode one day”.
The question we should then be asking is how long will the party continue before the punchbowl is taken away? Or perhaps a better question is, should I simply go home early and not hang around to see the stampede for the narrow exit?
Investors in shares, property and other high-priced assets can, at best, expect only low returns. At worst, violent volatility will accompany those low returns.
Low rates aren’t normal and they aren’t permanent, so don’t get used to them. Awareness of that fact should have you beginning to behave very carefully.
Roger Montgomery, The Australian August 6, 2016
BoJ props up government debt prices
The Bank of Japan’s surprise decision to target the level of Japanese bond yields has another purpose beyond figuring into the central bank’s inflation ambitions. The BoJ has effectively guaranteed the price of 10 year government debt, for now at least. It means the BoJ has killed off any chance that an epic bond market sell-off begins in Tokyo.
Bond funds were on edge heading into this week’s round of central bank meetings, of which the BoJ’s had the most at stake.
Speculation earlier this month that BoJ Governor Haruhiko Kuroda and his counterpart at the European Central Bank, Mario Draghi, had run out of stimulus options fuelled talk that the 35-year bull run in bonds had come to an end. The bout of selling was enough to lift German bund yields back into positive territory.
“The Bank of Japan is saying, ‘it’s not going to be us’,” said James Alexander, co-head of global fixed income at Nikko Asset Management. “One of the messages we take particularly out of what the BoJ has done is if there is to be a global sell-off in bond yields, it’s not going to be led by Japan.”
That’s because Mr Kuroda has introduced a zero target for the level of the 10-year Japanese government bond, one of the most highly traded assets in the world. This way, the BoJ protects bond investors from losses linked to negative yields by stepping up its buying when Japanese bonds are out of favour.
On Wednesday, the 10-year was yielding negative 0.037 per cent; Japanese markets were closed on Thursday. Given where yields are currently, the BoJ’s task is more about keeping them stable than lifting them higher. “It’s only really if the market tries to take it substantially away from zero,” Mr Alexander said. “You’re unlikely to want to take them on in that sense.”
Australian 10-year commonwealth government bond yields fell to 2.036 per cent on Thursday and 10-year United States Treasuries 1.651 per cent.
The US Federal Reserve kept interest rates on hold at its September meeting but raised expectations of a rate hike in December. At the same time, the Fed toned down its rate-rise profile and lowered its forecast for rates at the end of 2018 to 1.9 per cent from 2.4 per cent.
“We are a little bit confused as to why some of the members [of the FOMC] are so keen to lift rates,” Mr Alexander said, referring to the three dissenting votes recorded against the decision to keep the Fed funds rate at 0.25 to 0.5 per cent. “I think that there does seem to be this view amongst some of the committee that rates at zero just can’t be the correct rate.”
Economic data suggests the US economy still needs accommodative policy settings. “Normally when you see a central bank wanting to lift rates it’s because economic growth has been strong. That’s not what we see today,” Mr Alexander said.
“The bottom line is that certainly, the Bank of Japan believes they need to continue to support [the economy with] easy policy, I think there’s a flavour of that from the RBNZ. [The Reserve Bank of New Zealand on Thursday left rates at 2 per cent but signalled it wants to cut again later in 2016.]
“Then of course the US Fed has been talking about tightening all of this year. As much as they like to cheerlead their own economy, there is concern these economies need continued support.”
Vesna Poljak AFR 23 Sept 2016