Strategy & economics

And where are the clowns?

09/06/2015

Richard Jeffrey

Richard Jeffrey

Chief Economist

Have you ever watched a child blowing up a balloon? There is that initial huge effort necessary to turn the limp bag made of coloured rubber into a small globe. And then it seems to get easier with each successive puff. The balloon gets bigger and bigger, and the moment arrives when you know it is going to burst. But it doesn’t; it becomes even more extended. You do, of course, warn the child that the balloon is at capacity, but your warning is lost in the excitement of this wondrous object getting larger and larger. And you know what the denouement is going to entail. A sudden bang followed by tears.

And there you have it: the international bond market.

But bond markets have had additional help from a gaggle of evil aunties, who have used their much more powerful lungs to start inflating a new type of multi-coloured, extra-elastic, super-balloons, then handing them over to eager investors to keep them expanding to an awe-inspiring size.

Balloons do not always burst. But how many times have you seen over-exuberance engendered by the party mood take away a child’s normal caution?

I have written many times about the impact of quantitative easing (QE) on financial markets, particularly on bond markets. It is hard not to conclude that QE has been, if not solely then largely, responsible for the huge rise in bond prices that has been seen over the past few years. Indeed, a number of central bankers have suggested that the process of forcing down bond yields has been the main benefit of the huge liquidity injections that have been undertaken in most the world’s major developed economies, since lowering long-term borrowing costs, they argue, has been fundamental to reinvigorating economic activity. In this assertion, they conveniently ignore the observation that the one place you would hope to see the impact – productivity-enhancing capital investment – is the very area in which recovery has been so lacklustre.

So, is the bond bubble bursting? – probably yes. Rather than in one huge bang, however, there is likely to be a series of mini-pops – all with the potential to sting. We have already seen yields rise sharply in virtually all markets. As two examples, in the UK, 10-year gilt yields have risen from a 2015 low of 1.3% to the current 2.1%, while yields on German bunds have moved up from 0.1% to 0.9%. And there is likely to be more to come. For the UK, a theoretical long-term fair value yield is probably around 4%. It will likely take us a long time to get back up to this level, but it is not difficult to envisage yields rising by another one percent over the next year. Unfortunately for investors, this is unlikely to be a gradual process that allows calm decisions for residual profits to be taken (or losses curtailed). Rather, we are likely to experience a further series of mini-pops, during which there is little market liquidity. The danger, of course, is that we do see a spontaneous bursting of the bubble, which would undoubtedly be very painful.

I have long been of the view that central banks were taking a huge risk in following a policy course that deliberately caused mispricing of a core financial asset. But the risk is not just here. To date, QE has had its main impact contained within financial markets. However, as growth momentum improves, it is likely that the liquidity injected via massive central bank purchases of bonds will begin to have a wider impact. If this is the case, it is likely to be seen in excess credit creation and inflation. I commented last month that inflationary pressure could increase significantly more over the next year than is widely anticipated. But I am also concerned by credit growth. In this context, one number has caught my eye recently. When the last batch of money numbers was released by the Bank of England, most attention was on a surge in new mortgage approvals by banks. However, of much more concern were data showing that consumer credit outstanding in April was some 7.2% higher than a year earlier.

The widespread view is that what haunts bond investors is the spectre of rising interest rates. But what would be considerably more scary would be central banks forced into raising interest rates by increases in prices and lending that were clearly in excess of those consistent with well-managed and sustainable economic expansion.

This article is issued by Cazenove Capital which is part of the Schroder Group and a trading name of Schroder & Co. Limited, 12 Moorgate, London, EC2R 6DA. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. 

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