Francesco Filia – Measuring the Bond Bubble
A key conviction of ours is that we live through a Twin Bubble in asset markets: an Equity Bubble, particularly in the US, and a Bond Bubble, particularly in Europe. We know how we got here: the irresistible push of 10 years of massive passive public flows by major Central Banks (together with NIRP policies), which led to few years of large-scale passive flows by a private sector made of ETFs, risk parity funds, vol funds, trend-chasing algos. Still, the valuation issue remains, it affects expected asset returns from here on, and may therefore cause potential deep re-pricings along the way.
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Recently, in an attempt to measure the Equity Bubble, we referred to a measure of valuation such as the ‘Peak PEG’ ratio, which compares CAPE multiples of stocks in the S&P to the long-run rate of GDP growth for the economy overall. We adjusted for peak earnings, instead of average earnings, by taking the top two quarters in ten years; in so doing, avoiding the distortion in earnings during the Lehman crisis. It resulted that, against that valuation metric, the S&P was more expensive than ever before, including during the notorious tech bubble in year 2000. Oftentimes, we are told that stocks are not so expensive when compared to bonds, and their minuscule yields. Except that bonds are in a bubble themselves, offering little comfort to the endangered species of rationale investors. In this brief note, we look then at sizing up the Bond Bubble, to see how far we got away from normality.
In mid-2014, nominal yields on short-dated government bonds in Germany dipped down in negative territory, following the decision by the ECB to cut the depo rate below zero. At the time, GDP growth was in tatters across the Eurozone, inflation was deflation, and the existential crisis for the EU project in full display. Fast forward to today and German GDP is predicted at ~2% for 2017, inflation is at ~2%, the largest short-term threat to the EU survival (aka French elections) defused, all the while as the ECB, survey data, equity markets are all convinced the recovery is set to gather speed from here, and be ‘solid, broad-based in the period ahead’. Yet, short nominal rates on 2yr German government bonds are stuck at -0.76%, close to all-time lows, predicting that nothing much in policy will change well into 2019.
The thing is, though, that inflation moved from zero to 2% in the past 9 months, quite an acceleration, leaving real rates in a -2.5% deep hole in Germany and other core EU countries. Real rates are now more negative than at any point in modern financial history.
The comparison to growth rates, and long-run trend growth, is even more striking. Rationally, if negative rates were deployed to spur growth (through financial repression), and reduce unemployment (although not directly a mandate for the ECB), then it follows that now that growth resurfaced interest rates should adjust. The higher the growth rate, inflation adjusted, the higher the real rates the economy can take.
As growth picked up and rates did not, their relationship broke down markedly. The disconnect that ensued shows up as one of the largest to date.
Assuming long rates correlate to long-run growth, we then go adjust the level of real rates to trend growth. The resulting ‘Real Rates to Trend Growth’ ratio is literally off the chart. When compared to trend growth, government bonds in core Europe have never been as expensive as they are today. They are 200/250 basis point away from equilibrium.
In looking at small yields on govies from a different 'equity-like' perspective, legendary investor Warren Buffett complains about his largest portfolio holding, Treasury bills, yielding just 1%. He states how skittish he feels paying something 100x earnings, where earnings can’t go up. Holders of negatively yielding Bunds, for maturities up to 5 times over those of T-bills, can only look at that as a luxury.
Endless other ways to look at valuation on bonds can be used, most of which concur in pointing to the current times as an outlier in history. Nor should we really be surprised by such an outcome, as unprecedented, unconventional monetary policy does exactly what it says: unprecedented, unconventional stuff. Yet, to not be surprised does not imply to have to get used to, nor does it mean to forget the execution risks of never-seen-before policymaking, which are also unprecedented.
The ECB has a plan. Markets do not.
The stance of the ECB on this matter is clear. At present, the ECB sees no reason to panic for fears of rampant inflation, nor for financial bubbles. The ECB, in its forward guidance for 2018, sees no need for rate increases until well after the net purchases are over. The ECB also states that inflation needs to be close to 2% in the medium term, the convergence must be durable, self-sustained, and concern the whole of the region. In other words, inflation must be driven by broad-based robust demand and wage growth. Also, the EUR is turning the screws in anticipation of what seems inevitable, meanwhile offering yet another excuse for procrastination.
Yet, even on such contingency, moving through smoke and mirrors, the ECB presser and sources are consistent with a sequencing that sees the quantum in size and duration of Quantitative Easing to be discussed/decided in 6 weeks from now, and composition and rules of QE to be changed in December. It seems that the roadmap to adjustment is set. Fundamentals and valuations will come closer one another, somewhat. Soon, it seems. None of this is priced in, though, in bond nor in equity pricing. The EUR alone began to adjust.
Let us be clear. Nothing in this note is meant to say that it is a bad strategy on the part of the ECB. Rather, we just intend to point to the current valuation on Bunds and other core European bonds (govies, corporate and junk bonds) as fitting the classic definition of a financial bubble, insofar as a large disconnected to fundamentals in visible. As any bubble, it is unstable and unsustainable.
It remains to be seen how long the bubble can be blown for. Capacity issues matter, as at current rates, the ECB will have no Bunds left to buy in 6 to 8 months. In Germany, negative accruals on savers may also work as a countdown, as such a tax on capital is increasingly hard to justify. Ultra-loose money spur asset bubbles, in so doing exacerbating income inequality, which in turn viciously deters long-run growth. It may not be long before these arguments become the dominant narrative.
Easy money fuels asset bubbles, inequality
Cheap money helped asset bubbles and unproductive uses of capital, flooding to safe haven parking lots or seeking speculative gains from participating in credit-fuelled asset bubbles across