On the retreat….

Tuesday, 4th June 2019

On the retreat….

Bonds are pretty dull fare….

The character Jared Vennett (played by Ryan Gosling) in the film The Big Short summed it up better than I can….

‘If banking was boring, then the bond department at the bank was straight up comatose. We all know about bonds. You give ‘em to your snot-nosed kid when he turns 15; maybe, when he’s 30, he makes a hundred bucks. Boring.’

But boring or not, the bond markets are sometimes instructive….

They sometimes have something important to tell us….

And now is one of those times….

  • First, how bonds work….

Before we get into the nitty-gritty, it’s important to understand how bonds work….

I’m no expert, but here are the basics we need for our purposes today….

When you buy a bond, you are basically lending the bond issuer money. You buy at the current price and the lender pays you what is called a yield – like interest….

For the purposes of this column today, the important bit is this: the yield of a bond is inversely related to its current price. If the price of a bond falls, its yield goes up. If the price of a bond goes up, the yield falls….

The price of a bond tends to be reactive to the level of demand for the bond….

The price goes up (and yields go down) when there is healthy and growing demand….

The price falls  (and yields go up) when there isn’t….

And where price and yields are at any given moment in time tells us something about prevailing sentiment in the markets….

That’s why bond prices (and yields) are worth keeping your weather eye on….

They can tell you more accurately what is going on out in the real world than Phil Space in the Daily Blather ever will….

  • So, what’s going on right now…. 

There are all sorts of bonds out there on the market….

Governments, companies and all sorts of other institutions issue them to raise capital….

The ones we’re interested in today are the bonds issued by governments – here in Britain, in America and in Europe….

Right now, prices are going up across the board – and yields are falling….

In other words, right now investors must pay more to get into bonds than was the case previously. And when they get in, the rewards (the yields) for doing so are smaller than they were….

The United States is the world’s biggest economy and what happens there has a huge influence on what happens in other parts of the world….

So, it is worth looking at what is happening with America’s flagship government-backed bond – the 10-year Treasury….

And when we look, what we find is that yields have been steadily falling (and prices rising) since late last year….

In November, yields hit a 9-year high of 3.2%. Since then, yields on the 10-year Treasury have sunk to 2.1%….

That’s the lowest level since September 2017. And signs are that levels are going to keep on heading for the floor….

  • And it is happening elsewhere….

It’s not just in America that we’re seeing this trend towards lower yields on long-term government bonds play out….

It’s happening all over….

In Britain, Germany, Japan, Australia and elsewhere, the yields on long-term government bonds are hitting their lowest levels in recent years….

And they are falling fast….

So fast, that in some cases the yield curve has ‘inverted’ – which means that yields on long-term bonds are smaller than yields on shorter-term bonds….

That makes no sense….

In a rational environment, investors demand higher yields on long-term bonds than they do for short-term ones….

Their capital is  tied up and exposed to risk for longer periods in the long-term bonds. Investors would expect to be rewarded for that additional risk – and reasonably so….

But right now, the respective yields tell us that short-term risk is considered as high as long-term risk….

  • So, what does all this tell us?

Remember that the yield on a bond falls as the price of the bond increases….

And remember that the price of a bonds increases as demand for the bond grows….

What the falling yields are expressing is a sea-change in investor sentiment….

Investors are getting careful…. More cautious…. More fearful. They are taking money out of the stock market and other ‘risky’ investments and putting it into ‘safer’ income-producing bonds….

Hence, prices are going up and yields are coming down….

We can’t be sure why investors are feeling more fearful….

We might speculate about Donald Trump, the effects of his trade-war with China, Brexit and all the rest of the stuff that goes to make up the current smorgasbord of media headlines….

But all we can tell you for sure is that bond yields are steadily falling as investors and capital start to run for cover….

The tides of sentiment are on the turn. Exuberance is fading to caution….

Capital is not as confident as it was. Investors are on the retreat….

  • Why does it matter?

It probably doesn’t matter to your average Joe on the street….

But whether it matters to him or not, he is likely going to feel the effects and experience the fallout of what is ahead….

The thing about bond yields is this: they act on the economy in much the same way as barometric pressure acts on the weather….

When yields fall – as they have been doing and as they are doing now – you can expect a storm up on the road ahead….

Remember those ‘inverted’ yield curves I was talking about a few moments ago?

That doesn’t happen very often. Short-term bonds are seldom seen to be as risky as the long-term equivalent….

But every time that ‘inversion’ has happened in America over the last 60-years, a recession has swiftly followed on….

Not always immediately. But always within two years – and usually quicker….

Right now, the bond market is trying to tell us something. It is saying batten down the hatches. Things are going to get rougher….

And if you’ve got money in stocks. You might want to think about reallocating it to a safer haven ahead of time….

That’s the truth of it as we see it….

All the best,

Dave Gibson

Money Truths