In the WSJ, James Mackintosh writes,
with lower yields, bond prices move more for the same change in the yield, a concept known in the industry as duration. Bonds are riskier than they used to be.
The government of Austria has issued hundred-year bonds, which now yield 1.1 percent. If the interest rate were to fall to 0.55 percent, investors would double their money. If the rate were to rise to 2.2 percent, investors would lose half their money.
As a short-term speculation, maybe bond holders will get lucky. Long term, I would bet against them.
A separate WSJ story captures my sentiment.
“You’re either going to make very poor returns from government bonds going forward or you’re going to make extremely poor returns,” said Tristan Hanson, a fund manager at M&G Investments, who recommends investors buy equities and avoid bonds issued by Group of Seven governments.
Some 13% of the £117.27 million ($141.71 million) that M&G Episode Macro Fund is placed in a short bet against negative-yielding German government debt, Mr. Hanson said. The rationale is that “there is a limit on how far those yields can go even in an adverse economic scenario,” given the European Central Bank has set negative benchmark rates, he said.
Of course, it is superfluous to write stories about investors who are bullish or bearish on any class of securities. At any one instant, half the market sentiment is bullish on a security and half the market sentiment is bearish. If it were otherwise, the excess weight on one side or the other would move the price.
But in the case of bonds, my guess is that there are extreme differences of opinion. The short side of the market feels strongly bearish, and the long side feels strongly bullish. The bullish bond investors look crazy to me. By the same token, I must look crazy to them.
The super low interest rates, as well as negative interest rates, are the result of crazy central bank policies. To be bullish on bonds is to be bearish, or very bearish on the economy and predict further central bank craziness. Not a terrible bet. I doubt many but forced buyers are thinking long term. Somewhat like the dot com boom of 1999-2000, most knew it was crazy, but they were making lots of money from craziness and did not think beyond the fact they were making lots of money. I would argue Amazon’s current stock price is the result of central bank policies.
I’m not a finance guy, so this may be off-base, but the point about duration seems a little misleading. It may be mathematically true that if the market *100-year* yield doubles, investors get killed, but how variable is the 100-year yield? In other words, what events can happen that will materially change expected yields over the next hundred years? Certainly fewer things than change yields over a ten or thirty year period.
Austria introduced the bond two years ago at 2.1%, it is now 1.1%. Would you have asked the same question 2 years ago?
Well, I am old enough to remember people telling us that bond yields couldn’t ever fall below zero, so it was time to short them when 10Y Bunds were yielding 1%. I would have been old enough to remember this even if I were 13 years old today rather than 53. Who is to say 10Y Bunds can’t yield -5% or -10%?
A 10Y bond that yields -10% would effectively have a complete loss of capital over its life, so I would imagine that under no circumstances that would ever occur. It would have to be a trading position to get anywhere near that, but the potential risk exposure of that trading position would scare too many investors. A zero coupon bond with a -10% yield is priced at 286.79. The investor would endure a 42% capital loss if that yield snapped back even to -5%. Now rates in the current environment are pretty stable, but I suspect rates in a substantially negative rate world (like when they were substantially positive decades ago) would be much more volatile. If you’re going to expose yourself to that sort of mark to market loss and also a -10% YTM, why not just invest in positive yielding equities?
Currently, I think yields can go more negative than we’d otherwise expect due to institutional features: if you have $10 billion to invest, and you’re working for an institution like an insurance company, you can’t put it in a single bank or even a large number of them unless there is unlimited insurance. You also are bound to purchase bonds vs. other assets because they are safe from a principal protection. If I had to guess, we’d see a soft floor around -1.5% or -2.0%).
In a world with significant and sustained negative interest rates (e.g. -1.5% or lower), I think that changes. Firms will spring up which will exist to store/transfer money for a fee, say 30 or 50bps. Institutions would probably be forced to diversify into other assets, or park funds in these money storage firms. We’d eventually end up with a quasi-floor near the money storage cost.
Well the bond buyers are reacting to stocks overvalued a lot (Agree here) and long term all developed economies will turn Japanese since 1991. Basically there is a limited private sector long investments or consumer housing to invest in. (And/Or China is crowding out some of the long term investments from other nations.)
Anyway, the US went over the barrel in 2006 – 2008 so I believe it is someone elses turn and I believe it to commodity producers in Africa and South America turn. (It will interesting to see how China reacts as they did a lot of this investing.)
High Level I think Lyman Stone is correct overall:
1) Lower birth long term limits the amount of investment needs in the economy and limits the number of creation of new businesses.
2) Middle and working class wages have been stagnant for awhile. (Middle 2000 and working class 1974) So this inducing more employment credentials, slower family formation so cycle to Issue 1. (And we should note the fall of US birth rates since 2007 are been around single motherhood and poorer minorities so people are having less children for the right reasons.)
(Although I know you are not simple Keynesian but population growth is a variable that increase AD-AS in the long run.)
1) Lower birth long term limits the amount of investment needs in the economy and limits the number of creation of new businesses.
The world is expected to add another 3 billion people or so before birth rates are at replacement level. When those people achieve annual GDP of ~7,000 in todays dollars they will be adding a new (current) US sized economy to the world. Likewise many of the current 7 billion are currently poor but rising in wealth/income. Each $1,000 in average earnings increase across the world adds 1/3rd of the US economy to the world in consumption. It seems fairly obvious that the world shouldn’t be running out of investment opportunities nor job opportunities.
“Well the bond buyers are reacting to stocks overvalued a lot”
Why? The current S&P 500 P/E ratio is 21. The current dividend yield is 1.9%. What should the P/E ratio and dividend yields be for the stock market to be correctly valued in your opinion?
The mean p/e is ~15, 21 is 40% higher than that.
Yes, P/E ratios have been lower in the past, but that was when bond yields were much higher. In a long-term, low-interest rate environment, we should expect higher P/E ratios.
Your argument is circular, the S&P isn’t overvalued because bond prices are low, and bond prices are low because S&P prices are high.
The claim you responded to is that bond prices are low because stocks are overvalued, you responded with an argument that stocks aren’t overvalued.
Baconbacon, the valuation of each market makes sense in light of the other. Historical valuations don’t matter very much, as they aren’t part of the available investment opportunity set.
You want to save for the next 30 years, today. The 30Y UST is ~2%, about the same rate as expected inflation, less than it after tax.
The S&P, meanwhile, yields 1.9% but also should grow with nominal GDP (which I expect to be 3.5% across the cycle), for a 5.5% total return assuming a constant P/E.
Equities are also currently tax-advantaged, so many investors will pay a lower tax rate on capital gains and dividends than bonds.
The valuation spread between the markets makes sense. Equities have more risk, but have an expected return 3.5% above long term bonds. If bond yields spiked to 6%, then I agree current equity valuations would make no sense unless we expected much faster earnings growth.
“Baconbacon, the valuation of each market makes sense in light of the other.”
Uhh, yes, which is what Slocum said. Bonds have low rates because equities are overvalued, you can’t argue against his position by saying ‘equities are properly valued given how low bond rates are’. If your response is that the p/e ratio is ‘only’ 21 then it is reasonable to point out that is 40% higher than the historical average.
Going a step further saying that current p/e ratios are justified by low bond rates ignores that the current p/e ratio for the s&p is pretty in line with the 1990-2007 stretch when 30 year treasury rates were 2.5-3.75x higher than they are now, and the post 2007 highs are lower than the previous 40 year’s lowest lows, which support at least conceptually the position that an overvalued stock market drove down bond yields, and does not support the supposition that equities are high because bond yields are low.
If your model predicts a slight long term deflation, the low rate, long bond from Treasury looks ok. I think our double entry accounting system at the Fed does indeed so predict, we suffer a deflationary force. But our monetary system never survives a deflationary force for long before Congress rebels. So the long term bet is about that point of Congressional rebellion.