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“The good times are over”: Four things investors need to watch in the bond bubble

24 October 2016

Columbia Threadneedle Investments’ Jim Cielinski offers some insight into how the bubble playing out in bond markets will at some point start to deflate or even burst.

By Gary Jackson,

Editor, FE Trustnet

There are numerous signs that the extended rally in developed market government bonds has “reached the end of the road”, according to Columbia Threadneedle Investments global head of fixed income Jim Cielinski, although timing the bursting of a bubble is always a difficult task.

Cielinski (pictured) says most developed market government bonds are displaying characteristics of a bubble market after they became “overheated” through ultra-loose monetary policy and continued demand from yield-starved investors.

Highlighting how extreme valuations have become, he notes that more than $13trn of government bonds traded at a negative yield in the third quarter of 2016. While negative yields were first seen as a short-term reaction to quantitative easing and low policy rates, they have now become commonplace.

“The trend is provoking fears that bond yields are entering bubble territory. Negative rates, after all, virtually guarantee that investors will earn a negative nominal return on their assets, often on bonds of up to 10 years’ maturity,” Cielinski said.

“Never before in history has the market been confronted with lofty valuations of this magnitude. Below is one example from the UK, where bonds yields are at their lowest levels since records began in the early 1700s. This pattern is remarkably similar across developed markets. History, it would seem, is being rewritten.”

UK long-dated government bonds yields 1703 to 2016

 

Source: Columbia Threadneedle Investments, Bank of England, Bloomberg

But as bubbles are not defined by valuations alone, Cielinski takes a closer look other elements that can usually be seen when assets prices show a significant deviation from their long-term norms and offers insight into what it might mean for the bond market.

 

1. A sound rationale

The global head of fixed income points out that all bubbles have a rational underpinning, whereby the intuition and logic that allows them to embrace a particular market trend spirals out of control as excitement builds.

The dotcom bubble of the late 1990s is a good example of how readily a transparent story can quickly turn sour. On the back of the confidence in tech companies being transformational business with the potential for super-normal profits, investors failed to distinguish between value-adding firms like Cisco and Amazon or “imposters” like Pets.com.


“The underlying rationale never wavered, but rather gave investors the excuse to drastically overpay for all of these companies,” Cielinski said.

“Interest rates are low today for a very simple reason – growth and inflation are low, and are likely to remain so. Global GDP and global inflation have a long history of correlating strongly with interest rates. The current cycle is no different and fits well with investor intuition that rates should be depressed. So far, so good, but this is far different than saying yields should be this low.”

 

2. The ‘it’s different this time’ feature

Overvaluations can frequently be found in markets but investors can overlook them if they believe something transformational is taking place. Like the housing bubble that led to the financial crisis in 2007-2008 was built on the premise that homes were more affordable to more people than ever before, many investors act as though today’s supportive bond market conditions will never end.

Differentiating factors that some appear to consider permanent today include interest rates being at zero, growth and inflation remaining lacklustre, businesses and consumers being broadly unwilling to borrow more and higher saving rates among individuals.

“Monetary policy is largely exhausted, leaving central banks with limited scope to raise rates. It is perfectly understandable that bond markets have responded by pricing in a lack of growth and inflation over the short term,” Cielinski said.

“But the market has done much more than this, assuming there will be no pressure over the long term. The chart below shows the expected level of five-year real yields five years from now. Inflation and bond yield expectations have collapsed globally. Fixed income investors have come to believe it’s different this time, taking comfort from the perceived permanence of these factors.”

5yr real swap yields, 5yrs forward

 

Source: Columbia Threadneedle Investments, World Bank, Bloomberg

 

3. The ‘visible hand’

The so-called visible hand is a buying force that is both powerful and visible for all to see. This is another common element of bubbles as they led to a high level of confidence that asset prices will continue to rise.

In today’s markets, central banks are the visible hand driving the fixed income bubble thanks to their policy of buying billions of government bonds at any price in a bid to stimulate global economies.


“Central bankers are the bull in the china shop, distorting prices and making other market participants wary of fighting the trend even at seemingly nonsensical prices,” the commentator said. “The highly public nature of this large-scale buying creates confidence that someone will be around tomorrow to buy at an even higher price, and also that any sell-off will be contained.”

 

4. The ‘invisible hand’

Cielinski explains that the so-called invisible hand are flows that are more difficult to spot. They seem to repeatedly come to the rescue of markets and have the unfortunate effect of fostering investor complacency.

Examples include international capital flows, which have expanded due to globalisation, excess liquidity caused by central bank policies and some regions building up a surfeit of savings, and investors that have little option but to buy bonds, regardless of their prices.

“Pension funds and insurance companies require assured income to meet the promises they have made to savers and policyholders. Many have liabilities exceeding the duration and maturity of their assets. Lower yields worsen this mismatch, creating an acute need for many of these players to add more duration as yields move lower,” Cielinski said.

“Other financial institutions, such as banks, are being forced through regulation to add more safe assets. Together, these powerful forces have exacerbated the pro-cyclical behaviour of other investors.”

 

Source: Columbia Threadneedle Investments

He argues that bond markets have gone beyond pricing in a low-inflation, low-growth environment to pricing in a permanent low-growth, low-inflation backdrop. As the above table shows, all the elements of a bubble are present yet markets remain calm “with little fear that risks are elevated”.

Investors have been expecting rate rises for a number of years and they have never come through, so bond yields could fall even further in the short term on the back of issues such as global deflationary pressure and geopolitical uncertainty.


Cielinski said: “For investors, the million-dollar (trillion-dollar?) question focuses on when the bond bubble might burst. An old adage among economists states that one should attempt to forecast level, or forecast timing, but never both. Timing the end of a bubble is indeed dangerous.

“Overshoots are, by definition, part of the puzzle. The magnitude of overvaluation is therefore a poor indicator of an inflection point, as a combination of overvaluation and a catalyst is required. The catalyst often comes from an unanticipated source.”

He suggests that the ‘visible’ and ‘invisible’ hand categories are the ones where the most likely catalyst for a reversal will come. He highlights Asia as being one to watch: the Bank of Japan is at the forefront of monetary policy experimentation while a recovering Chinese economy could snap the bond rally if it leads to a reduction in its capital outflows, which are currently tended to head into government bonds.

“Studying the anatomy of a bond bubble is challenging. A final important lesson of bubbles is that they tend to end badly, but also that they end quite differently, and very often through unexpected channels. Timing the exit is always difficult,” Cielinski concluded.

“It is important to recognise today, however, that irrespective of whether or not the bubble is about to burst, the good times are over. Government bond valuations are simply too stretched, and the likelihood of additional positive catalysts too small, to argue for sizable gains from this starting point.”

Given this, bond investors should seek out products with low exposure to core developed market government bonds or low interest rate sensitivity. Bond funds with the ability to “aggressively” allocate to different sectors or emphasise non-core government sectors such as credit, municipal bonds and emerging markets could prove the most resilient, albeit with higher levels of volatility.

“We are witnessing the end of a multi-decade rally, and the unresolved question is a simple one: must we wait for a long while for this bubble to burst, or is an abrupt end just around the corner?” Cielinski said.  “The answer is not entirely clear, but will likely come from unexpected places, and will be heavily influenced by policymakers. Warning signs are looming.”

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