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Only time will tell if central banks are able to find
creative solutions to normalizing interest rates without a
disastrous side effect like a bond panic or a yield curve
inversion. In the meantime, investors have been allocating away
from equities and into bonds all year, with bond funds adding
$189 billion in assets year-to-date.
Within bond strategies there is a flood out of alternative
credit and more nontraditional areas of the market into the
lowest-yielding even negative-yielding
high-quality areas. The bond pile-up is alarming for several
reasons, and one needs to examine all the pieces of the puzzle
to see the bigger picture.
The first piece is the commoditization of fixed income.
Warren Buffetts quote comes to mind here: The
problem with commodities is that you are betting on what
someone else would pay for them in six months. The commodity
itself isnt going to do anything for you. ... Today
negative-yielding bonds more closely resemble
Bonds have long served as the anchor in a conservative
portfolio: a safe haven asset with an income component designed
to produce a consistent return stream. As the amount of negative-yielding debt exceeds
$10 trillion globally, bonds increasingly cease to trade
based on fundamentals, such as yield, in favor of what someone
else will be willing to pay for them in the future. For a prime
example, look no further than 4 percent
Swiss government bonds maturing in 2049. Today these bonds
trade above par at more than $130, giving them a negative
yield. With premiums of this magnitude, bonds are effectively
commodities, and investors are using the greater fool theory as an investing
The next piece of the puzzle is the false perception of a
high-yielding U.S. Treasury market. Compared with the negative
nominal yields in Japan and parts of Europe, the yield on U.S.
ten-year Treasuries appears attractive, trading at about 1.6
percent. Treasuries also look attractive compared with
government bonds from other developed markets such as Canada,
with 1.1 percent, or the U.K. gilts 0.7 percent or the
1.5 percent in South Korea. On a real basis, however, these
yields are significantly negative as well. Adjusting for
inflation, they range from 1 to 0.1 percent.
Furthermore, at a real yield of 0.7 percent, the ten-year
Treasury isnt even the best house in what appears to be a
very dangerous neighborhood for investors. From an endowment
whose return target includes inflation to individuals planning
on spending their retirement savings, this circumstance has
significant implications for many investors.
The final piece is the question of how much control central
banks really have over the situation. In our view at J.P.
Morgan Asset Management, it is tenuous at best. Whereas central
banks have shown they are extremely capable of driving rates
lower, they have yet to show their ability to drive market
rates up. Should we see more hikes from the Fed, what is to
prevent a further flattening of the yield curve? Last
years hike has already led to significant flattening. The
difference in yields between ten- and two-year Treasuries is a
mere 80 basis points. To put this situation in perspective,
this figure was close to 300 basis points in early 2010 and,
since the beginning of 2009, has averaged almost 200 basis
points, which makes the current spread two standard deviations
below the recent average.
So the Feds and other central banks
choices are either to continue to push rates lower, a
strategy that is proving to do nothing for economic growth and
actually hurts financials, or to push rates higher with little
impact on market rates and the added risk of creating panic in
the bond markets.
Perhaps this is one reason why weve seen the Fed
managing in accordance with market sentiment: interpreting
essentially the same constructive stream of economic data
differently, depending on where markets are at the time of a
meeting. The bottom line is that in the wake of unprecedented
central banks have painted themselves into a corner and lost
their ability to alter market rates.
So where does this leave us? One way or another, market
forces will eventually prevail and return the income component
to bonds. In the meantime, investors should consider
diversifying into strategies with a much broader toolbox across
traditional, alternative and private markets. This
recommendation is because a long-only, best-ideas approach
focused exclusively on public fixed-income sectors looks very
limited on the upside and is acquiring a meaningful downside as
the incongruence between economic data and central bank policy
grows. A more constructive approach would be to allocate to
strategies, not sectors: strategies that target a specific
risk-return profile and take a relative-value approach across
traditional, alternative and private markets from both a long
and short standpoint, as well as lend liquidity in exchange for
yield. This approach may be investors best bet at
continuing to find attractive, risk-controlled returns while
waiting for market normalization.