If everyone’s thinking alike, no one is thinking. Benjamin Franklin’s aphorism can be applied to today’s markets: if everything is going up, then somebody somewhere must be wrong.
In recent weeks everything from stocks to bonds and gold and even Bitcoin have been moving higher, but it’s not clear who’s in the right. The bond market is screaming trouble ahead, but stocks are merrily sailing along and are close to record highs. The S&P 500, the main US benchmark, managed to achieve a series of new all-time highs in June and July at the very time bond yields sank to the floor. We are seeing safe-haven demand rise at the same time as risk assets look well supported. The risk-on, risk-off pendulum is broken, or at least is swinging to a different beat. The only thing that seems to be down is the US dollar, which is feeding the demand for everything else.
Central bank trigger
So, what gives? It’s central banks of course. When stocks and bonds move together, there’s a belief that either the bond market is right, or the stock market is. Bonds tell us the economy is slowing, stocks suggest all is fine. Sooner or later we will learn which one is right. Actually, both can be right for a while because central banks are distorting the market.
Both the Federal Reserve and European Central Bank (ECB) have given markets the nod that they will be prepared to lower rates and reboot stimulus to combat the perceived lack of inflation. This dovish pivot, matched by the likes of the Bank of Japan, and central banks in Australia and New Zealand, has forced down yields and left investors searching elsewhere. Globally, with one or two exceptions that includes the Bank of England, central banks are looking to lower rates again. And in the case of the Bank of England, the market thinks a cut to lending rates is more likely than a hike, whatever policymakers say.
Quite why central banks feel the need to ease monetary policy is another matter but one that does lead us to other important questions. First of all, are they looking in the right place for inflation? Traditional gauges certainly show a tame level of price growth in western economies. But lower rates and unconventional policy tools such as quantitative easing only bump asset prices – and have done for a decade – a form of inflation that is arguably a lot more damaging to prosperity.
Second, are they happy to lower interest rates, or are their hands being forced by financial markets? The ECB certainly has little option. It missed its window to normalise policy and has been caught napping. And in the absence of structural and fiscal reform – blame Germany – outgoing ECB chief Mario Draghi can only tinker around the edges of the zero lower bound, hoping to weaken the currency to get some competitiveness back.
The Fed is in a different position in terms of US growth, but has nonetheless opened the door to rate cuts this year. Largely this is a reaction to financial markets – the tail wagging the dog. But there is optionality for the policymakers on the The Federal Open Market Committee (FOMC), who we should remember at present do not as a group believe that rates will be cut this year. The risk for stocks is that the Fed doesn’t play ball and refrains from cutting rates as deeply as the market wants.
Third, are they planning to lower rates because of missing inflation or because there is a deep concern about the global economy? If it’s the latter then the demand for safe havens makes sense, if the former then the stock market is actually the barometer that is offering the more correct signals, and this is primarily about liquidity and the hunt for yield. I would suggest it’s likely some of both, but more of the latter than the former.
In short, central banks look to the markets like they are back in the game of doling out support when it’s needed. This, partially real and partially anticipated, injection of liquidity is the prime reason that everything is up. Central banks are turning the monetary taps back on and this needs to go somewhere, hence why we are seeing demand for traditional safe havens.
Indeed, you could argue we’re in Goldilocks mode for safe-haven assets, despite stocks' near-record highs apparently telling us all is well. Of course, not all havens are the same. Rather like emerging markets, they’re all different in their own way. Nonetheless, you would have to say that a weaker US dollar, falling nominal and real rates, geopolitical tensions between the US and Iran, slowing global growth and elevated fears about trade mean havens are rightly in favour.
Bonds – are they really safe?
If you wanted something to illustrate just how crazy the debt market is, and the extent to which things have changed the in past few months, look no further than Austria’s 100-year bond. The hunt for yield is back with a vengeance, so Austria can get away with selling a century bond with a yield of barely more than 1 per cent. It did something similar in 2017 – the yield on offer then was in excess of 2 per cent, but has since come down by around 100 basis points. 1 per cent for 100-year debt just shouldn’t make any sense. Only it does start to look more rational when you consider German 10-year bunds are yielding a negative 0.3 per cent, while German notes due in 2048 offer a meagre 0.27 per cent. Slim pickings indeed.
Clearly, we are seeing distortions in money markets again after a period of normalisation. The contortions are being driven by central banks of course. Sovereign debt has rallied across the board and the stock of negative-yielding assets has soared to around $13 trillion (£10.4 trillion). Something like half of all European sovereign debt is trading with a negative yield.
The question is, with bonds commanding such high prices, can they really be considered safe? Is a 1 per cent ‘return’ on a 100-year bond to be considered a good investment? True, there is precious little yield to be had right now, but investors long on bonds could be caught out by a snapback in inflation and/or a rebound in global growth rates. If the US 10-year Treasury yield returns to 3 per cent there would be carnage. And in the case of the 1 per cent century bond, investors would need to get a telegram from the queen to justify the investment. US Treasury notes continue to offer the best ‘risk-free’ returns, but dollar hedging costs have wiped out the benefit for most non-US investors.
Bonds at these prices look overvalued and decidedly risky in the longer term. But as long as central banks provide the Kool-Aid, the market will guzzle it all down.
So, we continue to see the addict hooked on the drug. Efforts to wean the patient off the crack cocaine of central bank liquidity is proving fruitless – cold turkey may be the only way, however disruptive to the financial system it would be in the short term.
Gold – the ultimate haven?
If bonds are pricey, what about gold? A couple of years ago I asked whether gold would be able to withstand rising US interest rates. The answer was no, for a while at least. Gold fell by around $200 in the following 12 months as the Fed tightened and markets bet bond yields would break free from their 30-year downtrend. But the collapse in interest rate expectations, and in particular real US yields, has since sent gold skywards again.
Now gold could rise quite swiftly, to perhaps as high as $1,600, if real yields continue to fall and hit levels touched at points in 2015 and 2016. US 10-year Treasury yields fell rapidly in June to below 2 per cent, dragging down real yields and pushing up on gold prices. A return to negative real US yields would be incredibly bullish for gold. However, we don’t yet know whether the bond rally has enough legs to continue pushing down on yields. An awful lot depends on the Fed.
The 10-year Treasury Inflation-Indexed Security, or TIPS, is about the most widely used gauge of real interest rates and it’s telling us why gold is up. Real yields as measured by the 10-year TIPS have sunk, slipping to around 0.34 per cent, as inflation expectations have not come down as much as the benchmark yield.
Inflation expectations as measured by the five-year, five-year (5Y5Y) forward swap have been relatively stable compared with the sharp swings we have seen in benchmark government debt (see chart 1). Nominal yields are down a lot, inflation expectations are down but not by as much, hence real rates are much lower.
The correlation between gold and real yields is strong (see charts 2 and 3) and there seems a better-than-evens chance that gold will follow real yields if the latter continues to fall. If real yields in the US hit zero again, we could see gold top $1,600.
Meanwhile, gold isn’t just a hedge these days. It’s offering a better yield than about $13 trillion in negative yielding paper – 30 basis points more than the 10-year Bund, for example. The point being that not only is gold a safe haven in times of uncertainty, it’s also looking like a very smart investment when you’re being asked to pay to lend money to Europe and Japan.
Bitcoin – a new haven?
A sharp rally in Bitcoin coming just at the same time as a rebound for haven assets has plenty of wags talking up the cryptocurrency as a safe harbour. There may be a modicum of truth in this in as much as Bitcoin can be seen as an uncorrelated asset that is a hedge against fiat currencies. Bitcoin, like gold, yields nothing, so you can argue some similarity.
But going back to the central argument about both bonds and gold, this is more about liquidity than anything else. Investors are hunting around for somewhere to park money and with ever-declining opportunity cost of holding non-yielding assets, Bitcoin and other cryptos are viewed in a slightly different light than they would be in a more positive, pro-growth market.
However, doubts remain about the ability of Bitcoin to act as a reliable store of value and its liquidity is also questionable. June’s flash crash, when it shed $2,000 in a few minutes because of an outage on a major trading platform, highlights the problematic nature of seeing Bitcoin or other cryptos as a safe haven in any real sense of the term. The volatility is just too high.
Should investors be fearful?
A lot will depend on earnings growth as we head into the reporting season. This will offer investors a chance to see what expectations the major US and European corporates have for the coming year.
Even if earnings growth recovers, what about the macro data? Havens are benefiting largely on expectations of more central bank liquidity; it will take a strong period of growth and rising inflation that tilts policymakers back towards a tightening bias to stop this. The wild card is the gap between the Fed and market expectations. While the Fed says it doesn’t see any cuts this year, the market is very confident. Someone is wrong – if it’s the market then it could lead to serious gyrations in bonds and other haven-like assets as well as stocks.
Finally, amid all the ebb and flow, we just don’t know where the US-China trade war is going. There is every chance that uncertainty will persist well into 2020, by which time we’d expect Donald Trump to seek a deal he can paint as a victory, and boost Wall Street in the process. This could be the trigger for safe havens to lose their lustre, and perhaps nudge central banks away from further easing.