Rarely do we investors get a market that we know is overvalued and that approaches such clearly defined limits as the bond market now. That is because there is a limit as to how negative bond yields can go. Their expected returns relative to their risks are especially bad. If interest rates rise just a little bit more than is discounted in the curve it will have a big negative effect on bonds and all asset prices, as they are all very sensitive to the discount rate used to calculate the present value of their future cash flows. That is because with interest rates having declined, the effective durations of all assets have lengthened, so they are more price-sensitive. For example, it would only take a 100 basis point rise in Treasury bond yields to trigger the worst price decline in bonds since the 1981 bond market crash. And since those interest are embedded in the pricing of all investment assets, that would send them all much lower.
Those words are from the most successful hedge fund manager of all time — Ray Dalio.
When Ray speaks, you should listen. He’s been pulling money consistently from the markets over the last 30 years and has a long record of being right.
There is now more than $13 trillion — that’s trillion with a “T” — of global debt that offers investors a guaranteed loss if held to maturity.
The philosopher Nietzsche would remark (with some slight adjustments by me) “In individuals, insanity is rare; but in groups, markets, and economies, it is the rule.”
Insanity has to be an element in why “investors” would line up for a chance to pay to lend to a government. Should those who partake in this madness still even be referred to as investors? Is that not somewhat of an oxymoron now? Perhaps they should be called “burners” for all the capital they’re destroying?
Anyway, these burners are partaking in what can only be described as the largest game of “Greater Fools” in the economic history of man.
For those of you not familiar with greater fools theory (GTF), you need to be, because it seems to be the logic (or illogic?) at the foundation of our current bizarro capitalistic world.
Wikipedia defines greater fool theory as when “the price of an object is determined not by its intrinsic value, but rather by irrational beliefs and expectations of market participants. A price can be justified by a rational buyer under the belief that another party is willing to pay an even higher price.”
At Macro Ops, we define GTF as “insanely stupid and endlessly repeated moments in market history when a bunch of idiots start setting their cash on fire because they see other people doing it.”
Or there’s how 19th century editor of The Economist, Walter Bagehot, described it when writing about the 18th century South Sea Bubble. GFT is when “a great deal of stupid people have a great deal of stupid money… At intervals, the money of these people — the blind capital, as we call it, of a country, is particularly large and craving; it seeks for someone to devour it, and there is a ‘plethora’; it finds someone, and there is speculation; it is devoured, and there is
With over $13 trillion dollars (which is over half of all Western debt) held by bond owners that are assured to get a lower amount in return than their principal, I suppose we can all agree this is prima facie an example of GTF on a Godzilla scale. Here’s the following via the WSJ (bolding is mine):
The pull to par has become a drag: a buy-and-hold investor is guaranteed to lose money, even before taking inflation into account. The only way to make money is to find another buyer willing to pay a higher price—but that implies a bigger loss down the road.
The crucial thing to understand is that these instruments are no longer bonds—at least not in the traditional sense. With no income attached to them, they are simply bets on the price another investor is willing to pay. They will also be more volatile: the long wait for repayment means small changes in yield will have a big effect on current prices.
And so here we sit… at a peculiar moment in history where the most boring of boring and safest of safest assets, the plain old government bond, that sits at the top of our global financial system and is the foundation on which all other assets are valued, has now been bid well into “stupid” territory and more resembles a Dot Com stock or shares of the South Sea Company than itself.
Well... what does this mean? Where do we go from here?
Good question, so I’ll give you a good answer.
Dalio said at the top of this passage that “there is a limit as to how negative bond yields can go.” Those limits have been reached, so naturally that now leaves us with only one direction for rates to go… UP.
To see how we get to a higher rate environment when we’re in such a slow growth world, we have to turn to the avant garde of central banking — the Bank of Japan (BOJ).
Japan and its central bank made an interesting change to their monetary policy, which its significance has seemingly gone unnoticed by the mainstream investment community. I’m talking about zero rate targeting for 10-year Japanese government bonds.
Japanese 10-years were trading at below negative rates. So by targeting the zero bound, the BOJ is tightening policy. Why would a country that is fighting a losing battle against deflation want to raise longer term interest rates? The answer to this question is where the significance of this move lies.
By adopting a long-term interest rate target, the BOJ is handing over control of its balance sheet to the market. This is because no institution, not even a central bank, can set both the quantity and price of an asset. So by setting the price of 10-year Japanese government bonds at zero percent, the bank is effectively saying it will contract or (more likely) expand its balance sheet to whatever size necessary to keep prices there.
That in itself is pretty extraordinary, but the reason why the BOJ is doing this may be even more so.
Saddled with over 500% in total debt-to-gdp, Japan has backed itself into a corner in which there’s only one way out: inflation… and lots of it. It’s coming to grips with this although it has been slow to reach acceptance. But this looks like it’s finally changing.
The BOJ, by agreeing to backstop JGBs, and accepting an inflation target higher than 2%, is essentially paving the way for outright monetary financing. We’ve talked in the past about how Japan will likely eventually issue a perpetual zero coupon bond. This would allow the government to spend freely while also devaluing the yen (by a lot), thus monetizing the country’s debt. Well, this is the first step in that direction.
By keeping the long-term rate pegged at zero, the BOJ is allowing the Abe government to conduct large scale fiscal stimulus by issuing unlimited bonds while taking