Could bonds overreact?
Now, despite what the perma bears are telling you, consumer price inflation rising from near zero to 2% is in fact good news. For the past 2-3 years we have experienced a somewhat unusual environment, which has been characterised by strong inflationary and deflationary forces pulling in opposite directions and, for the record, we fully expect that to continue for several more years. However, at least for now, the consensus is building that inflationary forces will ultimately prevail, and the bond market is thus likely to overreact to bad news on the inflation front, or so goes Albert Edwardsâ argument. We would agree with that logic.
Despite all the noise coming from the bond bearsâ camp, in reality, bond yields are still trending down (see chart 4) and they remain below the levels of a year ago in both the UK, the US and in Germany (see chart 5a-5c). Admittedly, they are higher than the levels experienced six months ago, but if I had told you this time last year that the global economy would surprise with better than expected growth in 2010, the US and European economies would both surprise on the upside, commodity prices would generally be strong and energy prices would be particularly buoyant, would you have bet on bond yields being lower a year later? No, you wouldnât.
Conclusions
So what does all of this mean? The honest answer is that I donât know! Ireland could try to keep the show running for several more years before it eventually gives in, defaults on its debt and leaves the euro, but it could also take the bull by the horns, call the EUâs bluff and negotiate much better terms. Much depends on the bargaining skills of the team that the new government sends to Brussels to negotiate with the EU later this month. And EU peripheral bonds could be the best investment in the world over the next twelve months, or the worst, depending on how those negotiations turn out.
Meanwhile, the situation in North Africa could deteriorate quite badly with Saudi Arabia being the $64,000 question. Should the civil unrest spread to Saudi, anything could happen, including $200 oil prices. We could end up with not one but ten or twelve âIransâ on our hands â or the regimes in North Africa and the Middle East could accelerate their reform programmes, and new markets could open up to export companies in Europe and North America, much like the reforms in Eastern Europe twenty years ago created entirely new opportunities. I just donât know.
What I do know, though, is that much depends on how our governments and our monetary policy authorities react to all of the above. As far as the inflation outlook is concerned, I certainly hope that Ben Bernanke remembers his own conclusion from a research paper he produced back in 1997 and doesnât overreact to the current spike in oil prices:
âOur results suggest that an important part of the effect of oil price shocks on the economy results not from the change in oil prices per se, but from the resulting tightening of monetary policy.â
âSystematic Monetary Policy and the Effects of Oil Price Shocksâ, Ben Bernanke et. al., 1997
In terms of possible overreactions, I suggest you to take another look at chart 5c, representing the German yield curve. The key thing to note is the fact that, unlike in the UK and the US, short and medium term yields (those with a maturity of less than 10 years) have actually risen in Germany over the past twelve months, leading to a modest flattening of the yield curve versus a year ago. The market is essentially taking the view that the ECB will be the first major central bank to tighten monetary policy significantly. Given the fact that several countries in peripheral Europe are on life support, such a move will probably go down in history as one of the biggest policy mistakes of all times. Pay attention!
On the same theme, the Lex column in this morningâs FT pointed out that the US yield curve has flattened by about 20 basis points since early January. Again a sign that markets have begun to prepare for the end of âeasy moneyâ.
For all those reasons, we are taking risk off the table in our bond portfolios (see also the changes we make to our risk scatter chart on page 8). Not because we have become inflation hawks, because we havenât, but because we cannot get comfortable with all the unknowns. There are too many possible outcomes, not only in Dublin and Tripoli, but in Lisbon, Athens, Madrid, Tunis, Cairo, Amman, Manama, Muscat, Sanaa and Riyadh to mention but a few.
Niels C. Jensen
© 2002-2011 Absolute Return Partners LLP. All rights reserved.
ARP Risk Assessment Chart
We introduced the ARP Risk Assessment Chart in the December 2010 Absolute Return Letter, and have made it a regular feature since.
This month we are raising the probability of two risk factors â the risk of double dipping and the risk of premature withdrawal of monetary support.
Both of those changes are a function of recent events. Inflationary pressures are rising, even if temporarily, and that may force the hand of monetary authorities in both Europe and North America at a time where the recovery is still too fragile to be able to withstand such monetary tightening.
Furthermore, having raised the probability of food inflation induced civil unrest in mid January, we continue to monitor this risk factor closely. For now we are comfortable with classifying it as a medium impact risk factor. However, if the civil unrest spreads to some of the larger oil producers, we will increase the impact factor immediately.
1 The rapid growth in index-linked commodity products has also had a significant effect on commodity prices in our opinion. See the May 2010 Absolute Return Letter for an in-depth discussion of this issue.
2 âPrepare for a major over-reaction to higher US core CPI inflationâ, SG Cross Asset Research, 10/02/2011.
