At the end of every recession, the same heated debate invariably flares up: what shape will the recovery take? Will it be a V shape, with a speedy climb out of the trough? Or a U shape, with a more prolonged bottoming-out process? Pessimists speak of an L shape, where there is no real recovery at all, as in the Japanese scenario. And just for good measure, there is also a W shape, where a short-lived recovery is followed by a fresh period of contraction. This scenario, which is also known as a “double dip”, has gained in popularity in recent weeks.
Let me start by saying that double dips are extremely rare. A recession is usually followed by mutually-reinforcing processes that lead to a sustainable recovery. Of all the recessions which according to the National Bureau of Economic Research – the official recession arbiter in the
However, many economic data coming out of the
So is the
William De Vijlder
Global Chief Investment Officer, Partners and Alternative Investments
BNP Paribas Investment Partners
Are we facing a government bond bubble?
Earlier this week the Bloomberg website featured some interesting viewing: a video showing a US asset manager speaking about a bubble in government bonds, another video featuring a US investor telling us about “rationally fearful” investors, and finally an interview with commodities specialist Jim Rogers who argued that a new financial collapse could spark a commodities boom as the money tap is invariably turned wide open to fight such collapses. So you can take your pick. It makes you wonder: how disparate can opinions be?
The bit about “rational fear” is the least controversial: theUS data have weakened considerably in the past weeks and, more generally, more and more figures are lagging behind economists’ expectations – even in the growth countries. Small wonder that investors are getting nervous.
The assertion that we are facing a government bond bubble is a little more contentious. A bubble entails that an asset (usually equities, property or gold, but in this case government bonds) is significantly more expensive than is justified by the “fundamentals”. Some currently contend that bond prices are too high, which would mean that long-term interest rates are far too low. With German ten-year interest rates close to 2.00% and the US equivalent now below 2.50%, it is tempting to agree that - given our historical knowledge of where long-term interest rates used to be - “this is far too low, so a bubble is clearly in the making”.
Few would claim that current interest rates are at a normal level (‘normal’ being defined as the average over an economic cycle). The customary rule of thumb is that nominal long-term interest rates may not diverge too far from nominal GDP growth. Clearly, we are currently not living through an average period of the economic cycle: a lot of production capacity is lying idle, unemployment is high and substantial sums of money were spent on kick-starting the economic engine - which is already starting to splutter again, at least in theUSA . I discussed this matter with my colleague Guy Williams, chief bond manager at FFTW, part of BNP Paribas Investment Partners, and he reckons that based on the fundamentals (macro-economic variables such as inflation, economic momentum and so on) the theoretical ten-year interest rate in the USA should be 3.3%. That is certainly higher than the current interest rate, but the difference is no way nearly enough to be termed a bubble. Assuming a further deceleration in inflation and economic activity (a realistic hypothesis), then the “fair value” will decrease. So we are not in bubble territory, because the economic environment is far from booming. Interest rates for Germany are even lower and the economic indicators are stronger, so you could argue that the market is more expensive there than in the USA . Expectations of slower growth due to headwind from the USA and the use of Bunds as a safe haven on account of the troubles in the eurozone several months ago are at the heart of these low interest rates.
The investor’s reaction to these conditions depends strongly on the individual’s horizon. An extremely active investor can respond to the likelihood of a further slowing ofUS growth which will push long-term interest rates even lower. A “buy and hold” investor who buys today with the intention to keep the bonds for the next ten years is implicitly assuming a “Japan scenario”: years of weak growth, a flattening yield curve and deflation, so that even a nominal interest rate of e.g. 2% with deflation of e.g. 1% would yield an attractive real return of 3%. I still struggle to accept such a scenario. What’s more, we shouldn’t forget that the fall in long-term interest rates has made bond prices more sensitive to interest rate movements (the “duration” has lengthened), so if the economic environment were to improve, then the negative impact on bond prices would be much greater. Another consideration is that lower long-term interest rates should eventually stimulate the economy (empirical evidence shows that spending is much more sensitive to movements in long-term interest rates than to changes in the central bank’s official rates). It is interesting to note, incidentally, that the futures market is pricing in an increase in long-term interest rates: the Euro ten-year swap rate within five years is quoted at 3.2% which is 85 basis points higher than the current ten-year swap rate. Don’t take that 3.2% as a forecast for interest rates in ten years’ time, but look at the direction: the market is still convinced that long-term interest rates will not remain at their current low levels forever. Conclusion: an investor who buys ten-year government paper today with the fixed intention to keep it until maturity is being extremely bearish about the economy’s progress, not only in 2011 but for many years thereafter. Just to make it absolutely clear: this is not our scenario. Certainly, long-term interest rates may fall further first, but they must then start to rise again.
I will return to Jim Rogers’ view that a new financial collapse may lead to a commodities boom in a later article.
William De Vijlder
27 August 2010
Posted at 13:15 in William's Weekly Comments | Permalink | Comments (0) | TrackBack (0)