By Mike Dolan
LONDON: Far from embracing for what some dub the “great reflation” or even the “new abnormal”, bond markets are starting to see a post-pandemic world much like the one before COVID struck.
The past two months have seen a dramatic decline in US and global government bond yields – benchmark rates for most borrowing worldwide. That reversal snowballed this week as 10-year US Treasury yields fell to as low as 1.25% – almost half a percentage point below where they were in mid May.
Cheaper long-term borrowing may be a positive impulse in itself – but what it says about the market’s darkening view of the economy over the immediate horizon is another thing.
For an investment world that’s been obsessed all year about the speed of the post-COVID economic bounceback and the risk of inflation from government and central bank largesse – one still mostly eyeing 2% 10-year yields at least by year-end – this was not in the script.
Many of the major asset managers, still convinced of their narrative and diagnosis, remain unchastened by a vicious turnaround that many dismiss variously as either a speculative positioning reversal or technical in some way.
Others insist reading any fundamental signals from bond markets these days is a waste of time as central bank intervention has distorted them wildly.
All this may yet prove true.
But on the off chance the bond market is not broken after all, an alternative take is that the spectacular V-shaped bust and boom around the pandemic – a peculiar one-off cycle mandated by governments for health reasons – may be ending already.
And far from a return to the 1970s – or even 1920s – of go-go government spending that revives heady growth and long-dormant inflation, the world merely returns to where we were.
That pre-pandemic world was one of rapidly ageing societies in the West and China – filling an ever-expanding “savings glut” to fund retirement, depressing fixed income returns in the process and prolonging what became known as “secular stagnation” in economic demand, investment spending and growth.
The demographic picture, for one, has not changed. If anything, the pandemic triggered a baby bust rather the boom and has exaggerated ageing profiles considerably.
As ageing leads to greater demand for income generating savings rather than consumption today or investment in future profits – those savings gravitate to bonds more than equity. That in turn helps depress economy-wide productivity, potential growth and sinks ever further estimates of the mysterious r* – the theoretical “natural” rate of interest that allows the economy full employment or resources and stable inflation.
What’s more, the gigantic forced buildup of household and corporate savings through the lockdowns of the past 18 months may end up just topping up that brimming savings glut – even if large parts of these hoards are spent again or invested quickly.
Deutsche Bank strategist George Saravelos thinks neither the savings glut nor secular stagnation have been ended by the pandemic and markets will have to re-adjust.
“The single most important driver of the (bond market) moves are persistent and rising global excess savings as well as a pessimistic reassessment of medium-term trend growth,” he wrote this week as bond yields cratered.
Most of the fiscal spending over the past 12 months was one-off transfers that will expire soon, he said, and private spending would now have to take up the slack. The emergence of COVID variants also means vaccine optimism was perhaps greater than markets first hoped and may now stall recoveries in many emerging economies in particular, he added.
What’s more, Saravelos thinks a focus on the temporary spike in inflation rates has been misguided, potentially making things worse by forcing a tighter US Federal Reserve stance, weighing on medium-term expectations and flattening the yield curve.
“The market isn’t convinced that escape is coming any time soon,” he concluded, pointing to inflation expectations captured by US 5-year/5-year forward inflation swaps at 2.27% that are still more than half a point below the pre-2014 average.
Private consumption and activity are therefore more important to monitor. But there are signs these are already rolling over – or at least undershooting market assumptions.
Economic data surprises in China, which was first in and first out of the pandemic recession, have been negative now for over two months. And US equivalents have also fallen to the verge of “net miss” territory too.
Carmignac Managing Director Didier Saint-Georges said his funds were convinced the pandemic “mini cycle” was about to change and sky-high expectations of monetary and fiscal stimuli – and medium-term growth – were now being reined in.
“The market cannot ignore that,” he said, adding it was time to turn tactically to longer duration bonds.
And for all the hand wringing about the flood of official money in support of the recovery, liquidity experts have been warning annualised changes in these measures – which markets care about more than absolutes – have been ebbing for weeks now.
Investment fund CrossBorderCapital calculates that aggregate liquidity growth from the major central banks plummeted to a 6.5% annualised three-month rate at the end of last month – basically where it was before the pandemic. They blamed the Fed‘s aggressive daily reverse repo drains and base effects for the European Central Bank and Bank of Japan.
“Technical or not, liquidity is clearly weakening and – in the case of the Fed – even shrinking,” it said.