Bottom Line: Bond yields may stay absurdly low for quite a while longer, but eventually sanity will prevail and bond bulls will get killed. Don’t let Europe’s negative yields, and their spillover into the U.S., cloud your thinking about the appropriate PE for U.S. equities.
In the real world, as opposed to the make-believe mathematical world of economists, economies stagger from one mania to the next, much as drunks stagger from lamp post to lamp post. Often one mania corrects the imbalances created by the previous one. The current mania was captured in a recent FT headline: “Switzerland makes history by selling 10-year debt at negative interest rates.” German 10-year bunds yield all of 20 bps, meaning it would take 347 years for an investor to double his money. Debt with an aggregate value of several trillion euros carries negative yields.
This is really weird. It’s like telling your landlord, “I’m willing to stay in the apartment for another year, but forget about that rent check I’ve been sending you. From now on, you pay me $300 a month. Is that clear?” No reversion to sanity is imminent; Mario Draghi promises to stay the course on his bond-buying program. But it’s not all Super-Mario’s fault; Europe needs his monetary medicine because it refuses to make pro-capitalist structural reforms.
No Historical Parallels
To find out just how unusual negative bond yields are, I consulted UK interest rate data on measuringworth.com, the valuable compendium of historical data created by Lawrence H. Officer and Samuel H. Williams.* (I used UK data because, as a more mature and wealthy economy than the U.S., interest rates tended to be lower.) Between 1729 and 2014, the lowest annual bond yield was 2.15% in 1897—a hefty 221 bps above where Switzerland sold 10-year bonds last week. That 2.15% yield in 1897 occurred in a period of bona fide deflation; prices declined 0.2% per year during the prior decade. Today, by contrast, the UK is experiencing inflation of around 3%, so deflation provides no justification for today’s low bond yields, as some people claim.
It’s all about monetary policy. Central bankers are the new Masters and Mistresses of the Universe (move over Bernie Ebbers of WorldCom, Ken Lay of Enron and Angelo Mozillo of Countrywide Financial). They are vacuuming up bonds and driving up prices. Private traders are happy to go along for the ride. An HSBC strategist told the FT, “We have unconventional central bank policies at work so you have to expect unconventional outcomes. One is that bonds are no longer trading like bonds. They now trade like commodities, with investors speculating on the price.”
This notion that “bonds are no longer trading like bonds” is worth wrapping your brain around; it is this cycle’s analogue to Chuck Prince’s fatally prescient comment in July 2007, “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” My loose translation of the HSBC comment: These prices are crazy; there is no intrinsic value in bonds with negative yields. But who cares? We are speculating on short-term price changes, not investing. Whether it is tulips, tech stocks or houses, this is the telltale indication of a “bubble”—prices are being set by traders who don’t care if the assets they buy and sell have intrinsic value. The trend is their friend (until they fall off the cliff).
Bubbles 101: Five Facts to Keep in Mind
After making mistakes in the stock market for thirty years, I have a few observations that put the bond bubble in historical perspective.
- This bubble is quite unusual in that it is widely recognized as a bubble. Most observers understand that negative yields are ridiculous.
2. This bubble is not unusual in being government-sponsored. For example:
- The 1920s stock market bubble was partly created by the Fed, which kept rates too low for too long to help the UK keep the British Pound pegged to the U.S. dollar at its pre-World War I rate (which was far too high by the 1920s).
- The 1980s real estate bubble was encouraged by new “free market” regulations that allowed S&L’s (Savings and Loans) – which had nearly gone bankrupt in the inflationary 1970s because they had to fund single-digit mortgage loans by borrowing at double-digit interest rates – to make commercial real estate loans. Congress hoped the profits S&Ls made in this risky and unfamiliar area would restore their balance sheets. Instead they made lots of dumb (and often corrupt) loans to commercial real estate operators. Dozens of S&Ls went bust and had to be recapitalized; the real estate glut they funded did not clear up until the mid-1990s.
- Alan Greenspan kept rates too low for too long and drank the tech & telecom Kool-Aide. After warning about the stock market’s “irrational exuberance” in 1996, Alan Greenspan signed on to the “new economy” mantra of the late 1990s and failed to rein in equities—refusing, for example, to increase margin requirements in the equity market.
- Starting in the early 1990s, liberal Democrats, led by Bill Clinton, Andrew Cuomo, and Barney Frank, started to inflate the housing bubble by pressuring banks, as well as Fannie and Freddie, to make ever more risky mortgage loans to “poor and under-served communities.” Eventually they would be rechristened “predatory loans” by the liberals who promoted them.
Why this history matters now: Just because the ECB’s bond bubble is “official policy” does not make it safer and saner. Eventually it will blow up.
3. Bubbles Are Usually Inflated by an Economic Ideology. The equity bubbles of the 1920s, late 1960s, and late 1990s were based on classic “new era” thinking that productivity had accelerated and prosperity would last forever. The housing bubble was justified as creating an “ownership society” – the odd notion that owning a house catapulted you into the middle class, even if you couldn’t afford the mortgage payments, taxes, utilities, and maintenance.
Today’s bond bubble is unusual in being justified by a bearish mantra—the notion that economic growth is being stymied by Larry Summers’ fable of “secular stagnation,” which blames slow growth on debt and demography while ignoring the numerous policy errors that are really responsible. They include the dysfunctional design of the European Union, Europe’s socialistic policies, and Obama’s myriad policy errors (mismanaged stimulus spending, Obamacare, Dodd Frank’s regulatory overkill, higher marginal tax rates, the bank shake-down, the EPA attack on fossil fuels, failure to reform corporate taxes and recapture $2 trillion stranded overseas, etc.).
4. Bubbles Last Longer than You Expect, which tends to validate them until they finally pop. A few example:
- In the aforementioned commercial real estate bubble of the mid-1980s funded by deregulated S&Ls, Wall Street pros expected serious trouble by around 1986. But the collapse did not come until late 1990.
- Tech stocks looked expensive by 1996 but kept soaring for another four years.
- Housing looked frothy by 2005; the collapse came in 2008.
Before bubble finally burst, the bubble skeptics tend to fall silent because they have been so wrong for so long. In the 1990s stock bubble virtually all the bearish Wall Street strategists were fired before prices peaked. And while the naysayers fall silent, the bubble believers become more and more complacent, even as risks increase. Last week on Bloomberg Tom Keene talked to a longtime bull on bonds, who said, in effect, “For the past five years people have expected growth to pick up and the Fed to start tightening. They have been wrong so far and I think they’ll be wrong in 2015.” Congratulations on a great call, Mr. Bond Bull, but that was then and this is now. In 2010 unemployment was 9.5%; now it is 5.5%. Giant retailers like WMT, TJX and MCD are raising wages. Things do change; past is not prologue forever. The unexpected collapse in oil prices has extended the deflationary story for an extra year or so. But soon enough year-on-year oil price comparisons will turn positive and, with productivity growth weak and labor markets continuing to tighten, investors’ mindset could shift rather quickly from deflation to inflation.
- Manias Are Undone in Part by the Economic Distortions They Create. For example, the “free money” in the 1990s equity market funded over-capacity in tech and telecom, which produced a recession. The housing bubble funded vast over-building of real estate. Today’s negative interest rates will undermine life insurance companies and pension funds, creating major problems for the larger economy. Stay tuned.
When the bond bubble bursts in Europe it will spill over to the U.S., putting pressure on the PE ratios of U.S. equities. Don’t be surprised.
* Lawrence H. Officer and Samuel H. Williamson “Annual Inflation Rates in the United States, 1775 – 2014, and United Kingdom, 1265 – 2014,” MeasuringWorth, 2013.Copyright
Thomas Doerflinger 2015. All Rights Reserved.
