The death of bonds

    8 November 2014

    Bonds are meant to be boring. Yet lately the world’s most unexciting asset class has been anything but. At the end of September, Bill Gross, the manager of the world’s largest bond portfolio, the $290 billion Pimco Total Return Fund, jumped ship to a rival group before he could be shoved overboard.

    There had been reports of infighting at Pimco that led to the resignation of his designated heir, Mohamed El-Erian, and of curious behaviour by Gross, including appearing at institutional presentations wearing sunglasses; but the final straw was probably not so much executive hubris as the 17 consecutive months of outflows from his fund that totalled almost $80 billion.

    Gross’s departure from the group he founded in the 1970s may turn out to have no wider financial significance, but it feels like the end of an era: the great bull market for bonds began just a few years after Pimco was established and has entered its 33rd year. It is starting to look a little long in the tooth.

    The great paradox of our time is that even as the world chokes on ever greater mountains of government bonds, their yields have never been lower, as the chart overleaf shows. (Bond yields move inversely to their price — record low yields equate to record high prices.) Have the laws of supply and demand been repealed? A more likely culprit is central banks, which have stepped into the fiscal policy vacuum left by western politicians and bought government debt by the truckload to keep interest rates low and try to trigger an economic recovery.

    There will never be a counter-factual, so we will never know whether quantitative easing — the purchases of bonds from banks so that they might lend out these windfalls of new cash — has achieved anything other than inflating the prices of prime London property, bonds and stocks. But nobody can accuse central banks of being half-hearted. During its three separate bouts of QE, the US Federal Reserve has swollen its own balance sheet from $800 billion pre-crisis to $4.5 trillion today. In the process the Fed has expanded its leverage ratio (the level of its total assets relative to its core capital) to almost 80 times. By way of comparison, in 2007, just before it went bankrupt, Lehman Brothers’ leverage ratio was just under 30 times. Can a modern central bank go bankrupt? We may find out.

    You would be forgiven for asking why, if the central banks of the United States, Britain and elsewhere have been printing so much new money, we haven’t yet seen a rise in inflation — other than in the prices of financial assets. The answer is quite sobering: however much the world’s central banks have printed has been more than offset by the amount of deleveraging conducted by governments, corporations and households. We live in a debt-based monetary system. Whenever you deleverage (pay back loans), you extinguish money, and the overall money supply contracts. Central bank inflation, in other words, has so far been matched by the forces of private-sector deflation. To put it another way, credit bubbles of historic magnitude take years to burst. In the case of Japan, it has taken two decades and the process is still ongoing.

    In 2000 I met a Japanese equity fund manager who said something quite startling: ‘Japan has been the dress-rehearsal; the rest of the world will be the main event.’ That struck me as remarkably silly back then, but no longer does today. An analyst who would doubtless agree is Société Générale’s Albert Edwards, who has long advanced his thesis of an impending economic ‘Ice Age’: that global equities are heading for a huge collapse like that suffered by Japan’s stock market — which peaked in 1989 and has yet to recover — while bonds are set for a huge boom, because of global deflationary pressures.

    Deflation is entirely benign for the solvent consumer. It simply means lower prices, and who wouldn’t want that? The problem it poses for insolvent governments and other debtors, on the other hand, is little short of existential. Falling prices increase the real value of outstanding loans, making it harder for governments (and many mortgage-holders) to pay them off. It could hamper the economy by encouraging consumers to delay purchases; we can’t say for sure, because deflation has not been part of our economic landscape since the 1930s.



    There are already ominous signs of deflationary pressure in Europe. All German government bonds out to three-year maturities are trading with negative yields. That means lenders to the German government are paying it for the privilege of holding its debt. Nice work for the German government, but not so tasty for investors. And five-year German bonds now trade offering the same derisory yield (0.14 per cent) as bonds issued by that serial economic underperformer and deflationist horror story, Japan.

    Meanwhile there has been no slowdown in aggregate issuance of debt. The latest Geneva Report, issued by experts from Wall Street, the City and academia, points out that the global debt to GDP ratio has risen to almost 220 per cent in the six years since the global financial crisis. Sceptics, and for that matter realists, may conclude that the crisis is not yet over.

    It is certainly not over in the eurozone, where the banking sector, unlike its peers in the UK and the US, has done almost nothing by way of restructuring or capital raising. The president of the European Central Bank, Mario Draghi, told the financial community in 2012 that he would do ‘whatever it takes’ to save the euro. But the German central bank, the Bundesbank, having experienced hyperinflation during the Weimar era, is unlikely to give Draghi free reign to print ex nihilo money and use it to buy eurozone debt, especially that issued by weaker periphery governments.

    If you accept that the world’s unsustainable debt mountain is the single biggest threat to the integrity of our capital markets and economy, it is worth bearing in mind that there can be only three ways to tackle it. One is to maintain sufficient growth to service the debt. Throughout the world, but most notably in Europe, that now looks implausible. The second is to default. Since, again, we live in a debt-based monetary system, the default or repudiation of the debts of any major sovereign borrower equate to financial armageddon. There is a third option, and it is precisely this option that our central banks are resorting to with increasing desperation: an explicit, state-sanctioned policy of inflationism. But as fast as they print money, the banks (by deleveraging) destroy it.

    Consider that chart of bond yields again. The yields from UK government bonds, or gilts, have never been lower. Base rates have never been lower since the establishment of the Bank of England in 1694. At some point soon, UK base rates must rise, or Mark Carney will have some explaining to do. It is worth remembering the closest thing that financial markets have to an iron law: if interest rates go up, bond prices go down. A multi-trillion pound market is about to be kicked in the goolies. The only question is who will blink first: the Bank of England, or the Fed. If they decide to keep rates on hold, bond market vigilantes may return to do their dirty work for them. Now ask yourself two questions. If bond markets tank, what impact might that have on stock markets? And, not unrelatedly, what assets probably form the lion’s share of your pension portfolio?