In Bonds There Is Truth, But Don’t Expect Central Banks to Pivot Early

Blain’s Morning Porridge Oct 19th 2022 – In Bonds There Is Truth, But Don’t Expect Central Banks to Pivot Early

“If the answer is Jeremy Hunt, it must have been a really stupid question.”

This Morning:. In Bonds There is Truth – but until Real bond yields turn positive they remain financially repressive. If Central Banks “pivot” from tightening rates to address inflation too early, markets will remain fundamentally distorted.

What a marvellous world we live in. This morning I drove my wife to station, wearing my wetsuit so I could catch a quick swim against the tide as the sun came up, took puppy-dog for a yomp and stick tugging contest (top moment of the day), and then chatted with my rather excellent GP to review why I can’t get an appointment for follow up on something… and all before 8.30! And then I discovered our internet is down… Virgin pulled the plug and we have no idea why, except a dodgy call from India garbling about problems. Add them to sh*t company list.

What it means is the Porridge is late. Apologies.

Back to business. What’s wrong with markets today… ?

I always tell readers: In Bonds There is Truth… or at least there once was.. back in the mythical free-market Camelot of 1980-2008…

Government Bonds, be they Treasuries, Gilts, JGBs or Bunds set the “risk-free rate” from which all other investments are set. Because Gilts will always repay at Par, they set the rate from which businesses in the UK set their investment expectations, and investors determine the risks of other investments and what their book should look like in accordance with their risk appetite. The risk-free rate is the base line for everything in markets.

As we have discovered… play with the risk-free rate at your peril. It has triggered multiple consequences across the economy. 14 years of monetary experimentation and risk-free interest rate distortion enabled the everything rally in bonds, stocks and every other asset class you can think of.

Finally, the everything rally is unravelling, shaking the whole edifice of society, and predictably the market does not like it.

By distorting interest rates, the whole basis of investment was changed. Rather than analysing real world economic and business risks, investors began to front-run Central Banks juicing markets with artificially low rates. As bond rates fell, to secure returns investors were forced to either travel down the risk curve to take larger risks, or to use leverage to magnify returns.

Now that QE is over and quantitative tightening has begun (pulling money out the market as rates rise) markets have become uncertain – going back to value fundamentals. On the back of multiple crises, including energy and inflation, volatility has increased. This is when the problems really begin. As leverage and volatility bite, it becomes impossible to exit illiquid markets. That was basically what yesterday’s Porridge was all about.

We know that to address inflation aggressively Central Banks have to institute a controlled economic slowdown. That’s the equivalent of landing a Superjumbo on a very short Himalayan airstrip (mountain at one end, cliff at the other) with 1 engine and no undercarriage… in the dark, without crashing.

Now, there is now a dangerous belief in the Bond market developing that it will impossible for Central Banks to raise interest rates much higher. They expect a Fed Put will stem market losses.

Their scenario is bond yields now offer value against overvalued stocks, so its time to shift out of stocks and back into bonds. As central banks now need to “pivot” away from further interest rises to avoid an economic crash landing because of the vast, unsustainable amounts of debt in the Western Economy. If interest rates rise, it won’t just be UK Mortgagees that are crushed. Vast swathes of corporate industry will be busted, emerging markets will be crushed, and personal consumption will be obliterated.

There is an excellent article circulating in the market by my old chum Russell Napier – the Investment Sage of Edinburgh, and custodian and curator of the excellent Museum of Financial Mistakes. You should read it: “Will we see the return of capital investment on a massive scale”

Russel makes the point the last 15 years of deflation is over and inflation is creating a fundamental shift in the way our economy operates. It will be less free market, and more government based. What we saw during Covid Lockdowns were billions created by government to sustain the economy. What’s happening with Ukraine and the energy bailouts is the same thing. Governments did not hesitate to step in and stimulate economic activity through crises – continuing the precedent set in 2008.

Now we see interest rates rising in line with inflation. But negative real rates (where bonds yield less than inflation), is a form of financial repression; savers seeing the real value of their savings fall.  The only way to address inflation is to hike interest rates, but the whole government, corporate and personal sectors across Europe and the US are so utterly addicted to debt, heavily indebted and vulnerable to a massive downturn if rates continue to rise.

Raising rates is exactly what the central banks are telling us has to happen to contain inflation. The strong jobs numbers in both the UK and US are really lagging indicators of slowing economies – the fact Netflix is raising more new subscribers than expected is perhaps an indication of how little consumers understand about how much higher interest rates can go.

The bottom line is inflation is now deeply established in Western Economies. Its anything but transitory. We are seeing wage demands mounting – and it’s impossible to come up with an explainable, morally enforceable justification for paying public sector workers less of a pay rise than equivalent private sector workers have received to compensate for inflation. We’re seeing the end of China exporting deflation through cheap goods. We have real and war-triggered inflation. It may last a decade or more…

Until the Real Yield on government bonds is higher than inflation, investors and savers will remain repressed and the value of bond investments will plummet, pushing yields higher as demand drops – self correcting, but possibly to painful for governments to contemplate. To get elected they need to show gains.

Meanwhile, I have to giggle at Cathie Wood of ARK writing to the US Fed to warn them rapid interest rate hikes is a policy error. Anyone but your fault, eh Cathie? She says higher interest rates will trigger a “deflationary bust” Her ARK Innovation ETF is down 62% this year, largely on the back on higher interest rates crushing her “disruptive” tech speculative funding model.

The big risk is investors now seriously believe Central Banks will stop hiking rates to avoid a debt meltdown across the whole western economy. That is certainly possible to support and amerliorate government, corporate and personal debt. But to not address inflation will leave the economy further distorted.

What Central Banks hope is that markets will naturally reset – inflation will relieve the burden of debt, and economies will swiftly recover. But a financial reset is going to be massively painful across the economy. Especially for individual voters..

Maybe it’s time to look at other mitigation strategies – like a debt jubilee (debt forgiveness), making government debt held in central banks vanish, or finding a way to avoid massive corporate defaults…. How to do it without even more pain and misery is the problem… and its thinking about money and debt that keeps me awake at night..

Meanwhile, perhaps a devasting reset would be a good thing. There is a fascinating article in New Scientist: “The surprising role death plays in the stability of ecosystems.” It’s a neat way to look at why it’s actually important for the capitalist system to allow Zombie debt crippled companies to die because without failure the system can’t work. In periods of easy money, bad companies and bad investment ideas thrive.. when the system normalises, they have to fail..

Five things to read this morning

BBerg – Hedge Funds Are Betting UK’s Most Battered Assets Will Rebound

Businessweek – Mark Zuckerberg Isn’t Saying Much About Facebook These Days

FT – Will the Energy Crisis crush European Industry

WSJ – Vampire Squid Shuffle Aims to Reduce Reliance on M&A

Torygraph – UK is set for an almighty squeeze worse than 1976

Out of time, back to the day job…

Bill Blain

Strategist – Shard Capital