Wednesday, 16 June, 2021
(BBO) Robots Are Making Us All Buy Overvalued Bonds: John Auther
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2021-06-16 04:00:23.208 GMT
By John Authers
(Bloomberg Opinion) — To get John Authers' newsletter
delivered directly to your inbox, sign up here.Why Are Bond
Yields Doing This???
Last week I raised the question of why bond yields managed
to stage a significant decline around the highest inflation
reading in decades. We all know the arguments that this is
transitory, that the Federal Reserve will stay lenient, and that
President Biden will fail to get Congress to deliver a
meaningful fiscal stimulus, but these still aren’t enough to
explain what is happening. Investors seem needlessly exposed to
the risk that those sensible ideas turn out to be wrong.
And while the central bank’s massive intervention has much
to do with it, it’s too easy to blame everything on the Fed. As
Aneet Chachra of Janus Henderson points out, the U.S. Treasury
issued $6.68 trillion in the first four months of this year, of
which $1.73 trillion came from bonds of two years maturity and
upward. The Fed bought $320 billion over that period, which is a
lot, but still left $1.4 trillion searching for other buyers. We
know that there must have been plenty of investors who obliged,
but what can possibly have possessed them to do so at deeply
negative real yields?
This is when we look at the figures for institutional
savings plans. Over the last 12 months, investors have pulled a
net $108 billion from mutual funds and ETFs investing in U.S.
stocks, while putting an astonishing $785 billion into U.S.
taxable bond funds, according to Morningstar Inc. Bear in mind
that over the 12 months to the end of May, the most popular
stock ETF (SPY) outperformed the best-known bond ETF (TLT) by
62%, so this doesn’t look like great market timing:
What can possibly have driven such enthusiasm for bonds
over the last 12 months? Are people mad? Chachra picks up the
story:
Several years ago, my wife and I started contributing to a
529 educational savings plan for our two kids. Given the long
time horizon and high tuition inflation, I selected the
aggressive allocation option. But when I recently checked the
quarterly statement, I noticed the account was in a mix of
equity and bond funds. As our kids got older (they are now 9 and
11), the provider automatically moved them into a 70% equity/30%
bond allocation. And as equities rallied over the past year, the
plan periodically sold stocks and bought bonds to maintain the
target ratio.
It turns out that I’m among the investors buying low-yield
bonds. Also, about 5% of the account is allocated to a
diversified international bond fund. Roughly 60% of its holdings
are in Japan/Europe, so we’ve been inadvertently investing 3% of
our kids’ educational savings in no-yield bonds.
In this 529 plan, I can override the pre-set allocation
rules and choose a different weighting to stocks and bonds. But
I still have two uncomfortable choices. With stocks I take the
risk that they decline sharply in value immediately before our
kids start college. With bonds I’m accepting a likely below-
inflation return.
Automatic asset allocation funds are in general a good idea
(or at least, you will be able to find plenty of statements to
that effect from me over my career). They effectively force
people to adopt dollar-cost averaging and use a simple version
of market-timing, in which they sell assets that have recently
risen in price, while buying those that have fallen. Personally,
thanks to the beautiful numerical language of American
retirement planning, I have both 401(k) and 529 plans tied up in
target-dated funds. That means that I, like Chachra, bought a
big slug of stocks last spring (which is a good idea), but also
that I have been making steady sales of stocks while buying into
bonds ever since.
Regular readers may be aware that I don’t necessarily think
this is a great idea. Taking regular profits from stocks at this
level makes sense to me, but not if I then put them straight
into even more overvalued bonds.
More direct regulatory pressure has had an even more
dramatic effect on defined benefit, or DB, pension funds in
Europe. To their credit, regulators grasped several years before
the financial crisis that there was a risk DB plans wouldn’t be
able to meet their liabilities, and so required them to adopt
“liability-matching” — which in practice meant buying more bonds
to make sure they could cover their guarantees.
This means that Britain faces much less risk of widespread
pension defaults than the U.S, which is a real and important
achievement. But it has come at a cost. I recommend this piece
in the Financial Times by my former colleague and mentor Martin
Wolf, in which he proposes radical pension reform. He says:
The demand that DB schemes be made as risk-free as possible
has also had a dramatic impact on their ability to hold the
riskier assets that offer higher long-term returns. This makes
meeting pension promises still more expensive. Between 2006 and
2020, the weighted average share of DB portfolios in equities
fell from 61 to 20 per cent and the share of UK quoted equities
in that total fell from 48 to 13 per cent. So, the latter make
up just 3 per cent of DB portfolios.
His figures come from Britain’s Pension Protection Fund.
U.K. DB pension funds, which include plenty of money for people
a long way from retirement, now hold more than three times as
much in bonds as in stocks. If Chachra was worried to find that
he was inadvertently in a 70/30 asset allocation, how should
British savers feel about a 20/80 allocation? Pre-crisis it had
been almost exactly 61/39.
This may have saved savers from disappointment, but it has
done it very expensively, and has helped prop up bond markets at
extreme valuations. In a way, this is a form of financial
repression; the effect of regulatory action to make savings
safer has been to increase the cost of pension guarantees and
(by depressing bond yields) make government financing costs much
cheaper. One way or another, we’re going to lend money to Uncle
Sam, or Her Majesty’s Government, or other governments around
the world, at dirt-cheap rates. Whether we like it or not.
F!O!M!C!
The big event of the week is upon us. The Federal Open
Market Committee, which decides on monetary policy, is meeting
and will release a statement at 2 p.m. East Coast time, along
with a raft of new projections. Then Jerome Powell will give his
regular post-meeting press conference. Some kind of
acknowledgement of last week’s startling inflation numbers will
be necessary. Precise choice of words could have a market
impact. But Powell doesn’t need todo anything. The odds of any
change to monetary policy, beyond technical adjustments, are
tiny.
Despite the highest inflation number in almost three
decades, Powell has plenty of justification for staying the
course he has set, if that is what he wants. Unemployment hasn’t
improved as much as hoped in the last few months, and much of
the increase in inflation is obviously “transitory,” to use the
word of the moment. Further good news, as far as the Fed is
concerned, is that bond yields have fallen in the last three
months; even given the factors I mentioned above, this shows
there is still a presiding belief that the Fed will stay “lower
for longer,” and won’t be panicked into tightening policy.
The “dot plot” on which governors show their economic
projections, might conceivably show that that the median
prediction for when rates start to rise has been brought
forward. As it stands, 11 of the 18 voters say rates will be
unchanged by the end of 2023. Therefore, if two or three edge up
their predictions from there, the median projection for the
first hike would move closer:
How much does this matter, really? Not a lot. Most of us
can work out that this is fairly balanced, and that a lot can
happen in the next two years. Besides that, the Powell press
conference, and later the publication of the meeting’s minutes,
will give plenty of opportunity to cast this in a dovish light.
Words, for now, still matter,
And when it comes to words, classic number-crunching
techniques are being used to analyze central banks’
pronouncements. Oxford Economics produced word clouds of those
that recur most frequently in communications from the Fed, the
European Central Bank, the Bank of England and the Bank of
Japan. Here they are, and they show some interesting
differences:
It’s maybe not surprising that the BOJ never mentions
inflation, but it’s interesting that the ECB seems less
concerned than the Fed or the BOE. It’s also intriguing that the
ECB cares a lot about the euro while none of the other big
central banks ever say much about their currencies. The BOE is
bothered about growth; and it is telling that one of the BOJ’s
favorite words is “continue.” Maybe we should expect Japan’s
slow economy to continue.
As for the Fed, even if it talks more about inflation than
the ECB, it still doesn’t talk about it much. The FOMC seemed
more worried about it at the top of the brief boom created by
the Trump tax cuts, when it embarked on a policy of quantitative
tightening, or steadily reducing the number of assets on its
balance sheet. That concern almost vanished during the pandemic,
and remains low, as Oxford Economics shows:
The implication is that FOMC members really are prepared to
look through rising inflation for a while longer. And if all
this work analyzing word choices seems a little excessive,
Oxford Economics’ Fed Sentiment indicator, produced via machine
learning analysis of Fed transcripts, does seem of interest.
When the Fed’s governors appear particularly agitated, the chart
shows, yields tend to drop, and the relationship has grown a lot
closer in the years since the global financial crisis:
In principle, it’s not surprising that the bond market has
cleaved more closely to Fed sentiment in the last decade, as the
outlook for continuing support has grown ever more important in
these weird conditions. And if we return to the puzzle of why
bond yields stay so low, it may well be because investors are
doing a good job of gauging the central bank’s thinking. So as
we all brace for FOMC Day, the bottom line is that we shouldn’t
expect any great change of course; but that the intense efforts
to parse every word may actually be justified.
Ask Jeremy Anything
Next week, we will hold an hour-long live blog on the
terminal with Jeremy Grantham, the famed stock market seer and
founder of the GMO fund management group in Boston. It’s kind of
him to give us this opportunity, and to make the most of his
time, please send any points or questions to us in advance, to
toplive@bloomberg.net or by messaging my colleague Kriti Gupta,
who will moderate the chat.
Grantham has said a lot in the course of a long career. The
main topics we expect to cover include:
* His call that the U.S. stock market is in an “epic” bubble,
made here, and elaborated on here; you can see Points of Return
commentary on it here and here;
* His move to encourage investing designed to combat climate
change. His original white paper on this from 2017 is here; and
the follow-up from 2019 is here.
* His consistent belief in mean reversion, in the economy, in
profits, and in market returns. For his letters on this, see
here, here and here.
The live blog will start at 10 a.m., New York time, next
Tuesday, June 22.
Survival Tips
Two musical options to aid relaxation, on a day when we all
might have to concentrate on the complexities of monetary
policy. For something modern, I’d like to recommend Blackest
Blue, the latest album by Morcheeba. They’re best known for The
Big Calm, which came out more than 20 years ago, but they are
still making exquisite music, to back Skye Edwards’ beautiful
voice.
For something much older, I recommend Josquin Desprez, who
according to Alex Ross in the latest New Yorker was in many ways
the first great composer. He died in 1520, having produced
choral music of a level beyond any of his contemporaries, and
with a reputation as the musical Michelangelo — but little is
known about him, and many works attributed to him may be by
someone else. Whoever wrote the Missa Pange Lingua or El
Grillowas a composer of genius. And as the latter is about
crickets, it is good listening for this summer of the cicada.
To contact the author of this story:
John Authers at jauthers@bloomberg.net
To contact the editor responsible for this story:
Matthew Brooker at mbrooker1@bloomberg.net
https://blinks.bloomberg.com/news/stories/QUS0GNDWRGG2