Call That a Risk-Free Rate?

The phoney war looks fit to burst, with markets all-too calm and ready for action...

 

The U.S. BOND FUND manager Bill Gross titles his latest commentary 'A Sense of an Ending', writes Tim Price on his ThePriceOfEverything blog, and bond markets seem to have taken on an elegiac quality of late.

 

It feels like the uneasy period of near calm and heightened reality that occurs just before an outbreak of war. It may be that war has already been declared – on central bank price manipulation, by the free market.

 

The so-called 'risk-free rate' in Europe is best encapsulated in the form of the German government bond market. In the course of the last two weeks, the price of the long Bund (the German equivalent of a US Treasury bond), the 2.5% bond maturing in August 2046, has fallen from a price of €160 to a price of €135. That is a decline of 25% within the course of a fortnight.

 

Some risk-free rate.

 

Doubtless some highly leveraged corpses will float to the surface over coming weeks. If some central bank official, politician or bureaucrat issued a policy statement of import that might have been accountable for such a precipitous fall, we missed it.

 

Humans love a narrative, so the search for a plausible reason for the sell-off will no doubt continue. We think the likely explanation is a simple one, and Bill Gross alludes to it without specifically calling it. Perhaps the great bond bull market is over.

 

Bond fund managers will miss it. Obviously. It feels like Bill Gross is now on the wrong side of history. There is no need to mourn his metaphorical passing – a secular bull market in bonds that began in 1981 made him a billionaire in the process.

 

What equity fund managers will make of it is unclear. We think the omens are not particularly favourable, at least not in the major stock markets.

 

Robert Shiller's cyclically adjusted ratio of share prices to corporate earnings for the S&P 500 index – a smoothed average of historic P/E ratios – stands at 27.4 times. Its long run average is 16.6...and the US market, on a Shiller basis, has only been more expensive during two periods in history. The first was 1929, just before the Great Crash of the 1930s' depression. The second was the dotcom insanity of the late 1990s. Neither ended well.

 

In the Eurozone, the rough equivalent of a Shiller P/E flashing red lies in the Bund market. All Bund yields under five-year maturities are negative. Investors are welcome to buy debt securities that guarantee that long term holders will lose money, but we do not intend to join them.

 

Quite why investors are willing to behave this way is an interesting question. You'll have to ask them. One reason might be that they are terrified of all alternative assets. But that's like responding to a fire on the fortieth floor by throwing yourself out of the window.

 

Another reason might be that investors are front-running the European Central Bank, which has publicly stated that it will be buying €60 billion worth of this crap every month for the foreseeable future. This is known in the trade as Greater Fool Theory. As Warren Buffett pretty much said, if you're playing poker and having yet worked out who the Greater Fool at the table is, it's probably you.

 

The conventionally accepted reason for German bond yields offering guaranteed loss-making returns to investors is Quantitative Easing. Under a programme of QE, central banks conjure up money out of thin air and give it to financial institutions in return for their bonds. The banks are presumably then meant to lend this money back out, as opposed to hoarding it, which they appear to be doing. Somehow this crude inflationism is meant to ignite an economic boom. We may get a boom, but it may not be of the sort that central banks desire. It might be the type of boom that describes a loud, deep sound as from a gigantic explosion.

 

The conditions are certainly ripe for one. The independent analyst Russell Napier takes up the story. He poses the attractions of an innovative albeit hypothetical new fund, namely a room full of Euro banknotes. A few phrases in his analysis pique our interest. "A very dangerous world for equity investors" is one of them.

 

If bonds are a waste of time and the equity market is dangerous, and cash yields either nothing or less than nothing, what is the rational investor to do?

 

Not all equity markets are created equal, and clearly not all equities are, either. For most rational investors, equity as an asset class looks much more attractive relative to debt. The rational investor then looks to reduce his risk by only selecting equities that offer what Benjamin Graham called a "margin of safety". The rational investor today should attempt to buy the shares of high quality businesses with principled management without consciously overpaying for them. Such shares do exist, they just require veering off benchmark constraints.

 

UK investors are now watching in disbelief as David Cameron returns to Downing Street without any credible apparent opposition. This may turn out to be something of a pyrrhic victory. Despite its claims to fiscal responsibility, the coalition government accumulated more debt in five years than the previous Labour administration did over the previous thirteen. There are now the early signs of a bond market earthquake to match last week's political one.

 

After five years of phoney austerity, the real type must surely start now.