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Happy Friday. Someone out there understands the bond market. I hope they write me an email at robert.armstrong
Three ways of looking at a yield curve
It is a cardinal rule of good market commentary that one should not read too much into short-term market action. The efficient markets hypothesis, correctly understood, does not imply that prices adjust to new information instantaneously and correctly. It just means that the market isn’t any dumber than you are at any given moment. Markets, like people, take time to figure things out.
I will now break the cardinal rule. The Federal Reserve’s meeting on Wednesday was a big moment, so it may be worthwhile to take the market’s temperature, even right away.
Here is a picky chart showing the US government yield curve on Tuesday (blue) and then again on Thursday (orange) — that is, before and after the Fed’s announcements:
Broadly, the curve flattened. The short end and the middle saw yields rise a bit, but at the very long end — 20s and 30s — yields fell.
Here’s one way to look at this. The market looked at the Fed’s dot plot (showing where each Open Market Committee member thought rates would be in coming years) and said “these guys are ready to act if inflation gets any worse”. Here again are the dots from the March and June meetings, side by side:
All the hype on Wednesday was about 2023 dots, which implied that the committee expected two rate rises in ‘23. But Bob Michele, chief investment officer at JPMorgan Asset Management, argued that the 2022 change was the bigger deal:
“If you go back to a lot of the curve steeping that has occurred over the last 4 or 5 months, a lot of it was driven by the expectation that the Fed’s flexible inflation targeting would create a hot economy and higher inflation, and the long end had to compensate for that. This [flattening curve] is the market saying ‘Fed will lean into growth a bit.’ There wasn’t consensus that there would be no tightening in 2022. Seven members see a hike. That’s what the market is responding to.”
The logic is something like this: hikes in the next few years mean the middle of the curve will have higher yields. But in the longer term the Fed will kill inflation (with some real growth becoming collateral damage, possibly) and so on the other side of the increases is lower long-term inflation, growth and yields. Back to secular stagnation, even?
But there is another way of looking at this, especially at the long end. There is a staggering amount of money around the world that needs to earn some return, and as soon as the Fed gave the least hint that it would not let inflation go completely bonkers, that money rushed in into long US bonds, which are still yielding more than their German or Japanese equivalents. Here is Michele again:
Remember the sheer amount of cash on bank balance sheets, in money market funds, in the hands foreign investors sitting with zero yields. The Fed says [tightening may be] two years away. Why not buy the long end while you have a chance? We’ve seen a lot of flow come in from international investors in the last 24 hours.
Jim Sarni, managing principal at the wealth manager Payden & Rygel, pointed out that the stonking performance of stocks in recent years has increased the flow of money that is looking to rebalance into bonds:
Look at the performance of the equity market over the long term; against that backdrop, yields are higher than they were a year ago, making it an ideal situation for pension funds or insurers to remove uncertainty, lock in [gains], and take risk off the table.
So, the flattening yield curve may reflect the fundamentals of inflation expectations, or investor supply/demand dynamics, or both. There is a third possibility: that the market is hearing the Fed selectively. The dot plot is one thing, but chair Jay Powell’s comments painted a picture in which the Fed still considers inflationary pressure transitory, raising rates any time soon “inappropriate”, and will be talking about tapering asset purchases soon.
If that’s the right picture, isn’t buying (say) the 30-year at 2.1 per cent a little bit chancy? Jim Caron, a portfolio manager at Morgan Stanley Investment Management, thinks so: “I’m not a buyer of the back end at these levels . . . I can’t see the 30-year getting below 2 per cent and staying there.”
Michele agrees about the risks of buying long bonds with tapering coming: “Some investors refuse to accept the level of bond yields has been kept artificially low by central bank QE!”
The international option
Here is an amazing chart, which shows European stocks more or less keeping pace with US stocks since last August. Yay Europe!
The chart is amazing only because for years, the performance of Europe compared with the US has been awful. The result is that European stocks are much cheaper than American ones, relative to profits. So if European stocks are breaking out of their relative slump, there may be money to be made. And the same is true of all sorts of international stocks. Here are the 10-year rolling average price-to-earnings ratios of US, European, Japanese and emerging markets stocks:
The world is cheap! Shall we buy it?
I asked Ben Inker, head of asset allocation at GMO (an asset manager that is particularly keen on international stocks) about this.
He pointed out that much of the outperformance of the US was down to the stellar results of the Faang stocks (and Microsoft). That said, all US stocks have shot up, even those that are not outgrowing their global rivals: “The S&P 494 [the S&P without the Faangs] did nothing that was particularly impressive, next to the rest of the world, except for outperform” in price.
US stocks, Inker says, are relatively less economically cyclical than global ones. The rest of the world is effectively overweight industrials, materials and the like. If we are entering into a post-pandemic boom, that will help.
Next, if the Fed and other banks tighten, that should hit expensive US stocks harder. Some US valuations, Inker says, “make sense today if and only if you think interest rates are going to stay low forever. For the first time this week we are beginning to hear ‘when we say rates will stay low for a very long time, we don’t mean forever’ from the Fed.”
Fundamentally, though, the international trade is about the valuation gap:
“Why should international stocks ever outperform? They are cheaper. You don’t need their economies to grow faster, or their companies to grow earnings faster. You just need the earning yield to come through . . . Value is like gravity. It is the weakest of all the fundamental forces, but it operates on all timescales and in all places, and eventually you will be feeling it.”
One good read
My colleague Richard Waters has written a short, balanced profile of Lina Khan, who has just been confirmed as the head of the Federal Trade Commission. How she deals with big US tech companies is going to be important to tech investors in the next few years. If you are in tech, and haven’t read her famous paper about Amazon, you should.