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Bond Bubbles and Bad Endings

In a popular Bank of England blog earlier this year (4th January 2017), Paul Schmelzing from Harvard University analysed almost 800 years of economic history to understand the current episode of extremely low bond yields and attempt to forecast how it would end[1].

The key findings from the study are negative for asset allocators that rely on government bonds which are commonly used as defensive investments in portfolios to offset the higher risk (in terms of volatility of returns) of equities.

What did Schmelzing say?

“Looking back over eight centuries of data, I find that the 2016 bull market was indeed one of the largest ever recorded. History suggests this reversal will be driven by inflation fundamentals, and leave investors worse off than the 1994 “bond massacre."

Some important charts from the Schmelzing blog:

Chart 1: Length and size of bull markets since 1285

Analysis of the modern data period shows that ‘the United States (the current issuer of the global risk-free asset) experienced 12 modern “bond shock” years (shown in green in the chart below), during which selloff dynamics cost long-term sovereign bond creditors more than 15% in real price terms’. Emphasis added by us.

Chart 2: Macroeconomic outcomes in modern US bear markets 1925-2016

While a surge in inflation typically drives bond bear markets ‘some prominent episodes appear less correlated with fundamentals, and can inflict similar levels of losses’, according to analysis in the Schmelzing blog post.

Three types of bond reversals are identified:

· Type 1: Inflation Reversal. The classic fundamental shock: a sharp turnaround in realized consumer price inflation (CPI) as in the US in 1967-71.

· Type 2: Financial sector leverage and exogenous positioning shock– rather than only macro fundamentals as was the case in the 1994 ‘Bond Massacre’ where bond yields were rising ahead of US Federal Reserve rate hikes with spillover effects in vulnerable emerging markets.

· Type 3: VaR (‘value at risk’) Shock. Bond turbulence (as in Japan in 2003) can be highly discriminatory across maturities which makes it difficult to price securities and related assets with any certainty. This can be particularly damaging for banks ‘whose profitability in the maturity transformation business tracks prevailing curve steepness’.

Conclusion and Our View

Schmelzing has a dismal conclusion for the outlook for the sovereign bond asset class:

‘On balance, then, more than to a 1994-style meltdown, fixed income assets seem about to be confronted with dynamics similar to the second half of the 1960s, coupled with complications of a 2003-style curve steepening. By historical standards, this implies sustained double-digit losses on bond holdings, subpar growth in developed markets, and balance sheet risks for banking systems with a large home bias’.

Some factors to consider that moderate this outlook include:

· Still moderate US inflation and early financial market awareness of wages pressures though data flow requires close monitoring;

· Relatively clear signalling of monetary policy intentions by the US Federal Reserve;

· Excess capacity in the global economy outside the US accompanied by easier monetary policy; and

· Countervailing demographic forces that provide structural demand for income assets.

Overall, we are wary of the asset class and believe that the environment is likely to favour active fund managers with strong tactical capabilities.

Further information can be obtained by contacting us directly through the website.

Copyright ©2017 Douglas Funds Consulting Pty Ltd (ABN 92 607 747 240, AFSL No. 480438) (DFC). This report is subject to copyright of DFC. Except for the temporary copy held in a computer's cache and a single permanent copy for your personal reference or other than as permitted under the Copyright Act 1968 (Cth), no part of this report may, in any form or by any means (electronic, mechanical, microcopying, photocopying, recording or otherwise), be reproduced, stored or transmitted without the prior written permission of DFC. This report may also contain third party supplied material that is subject to copyright. Any such material is the intellectual property of that third party or its content providers. The same restrictions applying above to DFC copyrighted material, applies to such third party content.

[1] Source: https://bankunderground.co.uk/2017/01/04/venetians-volcker-and-value-at-risk-8-centuries-of-bond-market-reversals/


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