In recent editions of The View, we observed that world asset markets in early February were jolted by strong US economic growth indicators. Sustained US employment growth and rising wage rates led markets to speculate that inflation was a foreseeable risk. The interplay of markets meant that rising yields (bonds and corporate debt) led to a fall in the “price earnings ratios” of equity markets. However, despite increased price volatility, markets have held together.
Figure 1. MSCI World PE
Source. Thomson Reuters
Australia did not escape with bond yields lifting across the maturity curve and the equity market declined in the March Quarter – but at about half the rate of the US market.
Figure 2. Australian Equities Total Return
Source. IRESS Market Technology
The interplay of asset markets, particularly equity and debt markets or growth and yield, is important to observe. Historically it has been the sharp reaction or retracement of interest rates that have warned of economic downturns and pre-empted upturns. Market interest rates, from short to long dated, are normally driven by market expectations of economic growth and inflation. However, since quantitative easing (“QE”) became a mainstream and excessively used tool of Central Banks, the warning lights of interest rates have dimmed.
We propose in this publication to investigate the interest rate market through a range of charts. Our conclusion is that interest rates will rise very slowly over the next few years. Therefore investors, particularly self funded retirees, will have great difficulty in generating returns from traditional yield investments – bonds and bank deposits.
As income investments mature and are rolled over, the replacement yield is low and may not be sufficient to meet the cashflow needs of pensioners. Their choice is simple – take on higher risk to generate meaningful income or draw down capital to supplement pensions.
The decision for a relatively young retiree (say, under 75 years of age) should be to take on some risk, aim to maintain capital and acknowledge the increased capital volatility that will result. An older or more risk averse retiree may well decide that volatility is to be avoided and a lower yield supplemented by capital drawdown is preferred.
The decision is investor specific and requires a full analysis of individual circumstances that considers both super and non super investments. In reaching an asset allocation decision, an investor needs to acknowledge both the investment environment and the outlook. We hope the following charts are instructive in this endeavour.
Recent bond yield history – Japan bonds are lost
Our first chart shows that today’s world bond yields (average maturity) are the lowest in 68 years. The chart shows the historic range of yields for major developed economies. Australia has had an average bond yield range of between 5% and 7%. Today our average bond yields of around 2.5% are well outside this range.
Figure 3. Sovereign Bond Yields
Source. Bloomberg; RBA
The negative average yields on Japanese, German and Swiss bonds stand starkly in the way of any claim that a “bond collapse” has begun. While bond yields have increased since January, they have hardly taken us into dangerous territory – far from it!
While yields have not moved to disturbing or worrisome levels – the maturity profiles of some bond issuance have. The next chart shows that Austria recently became the fifth nation to issue 100 year bonds. Argentinia set the precedent but its bond owners possibly had no choice – take a write off, or roll for a hundred years – and are somewhat compensated by an 8% yield. However, Austria was probably stimulated by the yields presented on Irish and Belgian 100 year bonds that pay their owners (and cost the borrower) just 2% on market prices.
Figure 4. Issuers of 100-year bonds
The issue of 100 year bonds at historically low yields represents a breakdown in bond market metrics. It is a practical example of the beginning of the forgiveness of government debt inside bond markets; an implicit acknowledgement that trillions of government bond debts will probably never be repaid. The renegotiation of debt by managers of debt out to a hundred year repayment period suggests to us that returns from long term bonds will be poor for the forseeable future. They can only “outperform” by protecting capital in the event of a calamity. So is the bond market predicting a calamity, or is it affected by other influences?
Our view is that current bond prices don’t indicate calamity. Rather, we perceive that the participants or managers of capital in bond markets have simply been engulfed by QE. There are stark examples of capitulation across Europe and Japan where bond yields are negative out to 7 years duration. Further, the size of the government debt arguably swamps the natural ability of bond markets to efficiently or effectively clear the debt. It is not possible for the bond market to act independently of central bank support or manipulation.
Our next chart shows the largest five issuers of government debt.
Figure 5. Top five nations, by total government debt securities issued as of September 2017
Source. Bank of International Settlements
Bond market capitulation is at its extreme in Japan where GDP of US$4.8 trillion is swamped by government issued debt of US$9 trillion. The capitulation is shown both in yield and in bond turnover. The Japanese bond market – the active buying and selling turnover on any given day – has fallen to extremely low levels. Japanese daily bond turnover is commonly measured in millions and recently (on March 13), the newest 10-year bond issued by the Japanese Government didn’t trade at all on the main bond market. That has happened only seven times in the 24 years of data and six of those times were in the last four years. It is noteworthy that the Japanese Central Bank (BoJ) owns 71% of all ten-year Japanese bonds on issue.
While interest in Japanese bonds has “dried up” so too has liquidity – sorry for the pun. Direct comparison to the US is difficult, but average daily trading volume in US Treasury bonds with maturities between six and 11 years was $112 billion in 2017. Therefore, on a relative basis, Japanese bonds should be trading around $50 billion per day.
Recently, a long term Japanese bond manager was quoted as saying –
“It’s becoming like a deserted village. All that’s left is for us to fade away and die,” said Jun Fukashiro, who oversees bond investments for Sumitomo Mitsui Asset Management Co. The 53-year-old asset manager, who has been involved in government bond investing or trading since 1990, says that when he goes out with people in the business, he just sees the old faces, “the ones who are headed for retirement pretty soon.”
Activity has especially shrunk since September 2016, when the BoJ said it would seek to keep the yield on the benchmark 10-year government bond around zero. In doing so, it continued with an open-ended QE policy that has so far resulted in it owning 41% of all the Japanese government debt on issue.
Figure 6. Percent of JGBs held by Bank of Japan
Source. Bank of Japan
It is our view that the monetary settings and QE policies of Japan, Europe and even the US will continue to dictate interest rates in Australia.
When reviewing interest rates, there are 3 main markets to consider. These are cash rates (dictated by central bank settings), bond yields (affected by QE) and corporate bond yields (priced by credit spreads). It is this latter market which is arguably freer than the first two and therefore presents investors with some opportunity to find reasonable yield. The corporate bond market is also the best market to review when determining what capital markets are really predicting.
Cash rate settings
While the US Federal Reserve (Fed) has adjusted cash rates higher, there has been no response by the European or Japanese central banks. The US is going it alone and while another two rate rises are expected in 2018, there will be a point where the Fed will stop and wait for its peers to catch up. If US cash rates move to 2% above comparable rates in Europe and Japan, a flood of speculative capital may flow into the US, forcing the USD higher and depressing US trade competitiveness.
Figure 7. Policy Interest Rates
Source. Central banks
Australian cash rates are at their bottom (according to RBA statements) but sit well above European and Japanese cash rates.
Figure 8. Australian Cash Rate
The RBA is not confronted by excessive Commonwealth Government debt – no need for 100-year bonds here – but it remains concerned with a highly indebted Australian household sector.
The following table shows that Australian households are making principal mortgage repayments at a reasonable rate, but they have begun to fall again as too many interest only loans were written in 2015/16. The fall in principal repayments (above schedule) is a disappointing outcome given the historic low interest rates. Again, this suggests to us that the RBA will hold cash rates steady in 2018.
Figure 9. Household debt-to-income ratio & payment-to-income ratio
Observing the international bond market, we note that US growth numbers (presented in early February) had the most profound effect on US bond rates, followed by Europe and less so for Japan. At this point, the ECB is guiding bond investors by indicating that their bloated QE program will continue through to the middle of 2019. In the US, a QE tapering has begun and the Fed balance sheet reduction (net asset sales) has commenced. To our point that there is no evidence of a bond rout, we note that world bond yields are below 2014 levels and barely above GFC levels.
Figure 10. 10-year Government Bond Yields
Source. Thomson Reuters
In Australia, our bond yields are significantly below GFC levels and barely above all time lows. In our view, the ten year Australian bond is not predicting an outbreak of inflation nor indeed a dramatic rise in cash rates. Therefore bank term deposits will not be rising by much anytime soon. There is no relief in sight for pensioners waiting for higher bank deposit rates.
Figure 11. 10-year Australian Government Bond Yield
Source. Thomson Reuters
Since February corporate debt costs have risen, represented by higher corporate debt rates (“spreads above bonds”). In the US, there has been a “double whammy” with corporate spreads rising on top of higher bond yields.
The effect is captured in the table below which shows that US corporate debt spreads (AA – BBB) have risen by about 30 basis points (0.3%) on top of bond yields that have also risen by about 0.3%.
Figure 12. US Corporate Bond Spreads
Source. Bloomberg; ICE Data
In Australia, corporate bond spreads have barely moved, holding their margin above slightly rising government debt rates. So while Australian corporate rates have risen, they have not jumped as fast as US corporate debt rates.
Figure 13. Australian Corporate Bond Spreads*
Source. Bloomberg; RBA: UBS AG; Australia Branch
Investors are confronted by an extraordinary interest rate environment. In Australia, the RBA has set “real” cash rates at below the inflation rate and therefore created a negative real cash yield. The sustainablility of this is in question, but as noted above the offshore influences are simply too persuasive.
Figure 14. Australian Cash Rate and 90-day Bill Yield
Source. ABS; ASX; RBA
In conclusion, some history: the relationship in the US between inflation, PERs, bond yields and tax rates.
Our final table shows that bond yields are strongly influenced by inflation (actual and expected), and it is a feature of the last decade that real long term interest rates (10 year yields less inflation) have fallen to historic lows. We can observe that inflation is tracking at historic lows, and the medium term outlook is for more of the same.
The risk to this outlook is a trade war (we already see compromises between US and China) or a blow-out in oil prices – but these are currently supported by OPEC production cuts and thus are not likely to be sustained for more than a year.
Figure 15. Average inflation, PERs and 10 year bond yields
Today, US ten year bonds are trading at a yield of about 2.85%. Last week, US inflation was reported at 2% per annum and our expectation is that US ten year bonds will rise to above 3% over the remainder of 2018.
Our forecast rise in real US bond yields to just 1% above observable inflation is based on our view that European and Japanese Central Banks will continue with their excessive QE policies. While the 1% real margin is low and not supported by historic observations, the flow of bond capital from Europe and Japan cannot be ignored and will suppress US rates.
So our forecast is this: oppressive yields in Australia will continue for the next twelve months (at least). Investors will need to investigate direct property and corporate debt or bonds to generate meaningful yields. In addition, we might need to re-visit those listed companies whose shares are yielding dividends above 6% … provided of course that we can determine that such dividends are sustainable. We might leave that question to James Bond?