The weirdness in financial markets at the moment seems boundless.
In the past two weeks the proliferation of negative-yielding bonds has erupted — 30 per cent of the global, tradeable bond universe is being sold with a guaranteed loss attached to the coupon.
That’s an eye-watering $US16.7 trillion dollars’ worth; $25 trillion in Australian dollars.
The bizarre concept that the safest bet in the market — holding a bond to maturity — costs you money mutated out of the global financial crisis as several, notably European, central banks kept cutting interest rates all the way below zero.
The Bank of Japan joined in five years ago and the new financial black hole started to expand — at first sucking in billions, now trillions from large financial institutions such as pension funds and insurers.
In effect, creditors willingly enter a deal with debtors knowing they are going to get burnt.
It turns the whole financial world on its head. Just imagine a bank giving you a mortgage and saying “don’t worry about the repayments, we’ll pick up the tab”.
The quantum of negative yield debt doubled to $US14 trillion in the first half of 2019; its growth now appears to be hitting warp speed.
Market value of negative yield bonds as a percentage global bonds*
More than 30 per cent of bonds issued in the world have negative yields, and it is rising rapidly. (Source: Bloomberg, J.P. Morgan)
*Calculated as percentage of total outstanding bonds in Bloomberg Barclays Global Agg Index at 15/8/2019
Germany, Denmark, Netherlands and Finland now have all their bonds across the spectrum — one year to 10 years and beyond — trading with negative yields. The likes of Sweden, France and Japan are not far off being totally negative too.
US 10-year yields remain in positive territory — but only just, and it is trekking down, as is the yield on Australian 10-year Commonwealth Government bonds.
US Treasury bonds have just inverted, with yields on long-term 10-year bonds falling below two-year returns causing all sorts of market conniptions and raising fears of a recession around the corner.
That’s put more pressure on the Fed to cut and cut again.
A cut here, a cut there, a decent economic contraction and another $US16 trillion worth of US bonds is in danger of sinking into negative yield territory.
Given the prospects for global economies are sagging and there’s hardly a flicker of inflation to be spotted in the gloom, it’s hard to see how things don’t become more negative.
So should we be worried?
Well, yes. It might be the arcane and barely comprehensible world of global finance, but there are troubling precedents for the explosive growth of things that seem to make little financial sense to the ordinary punter.
Abstract ideas like collateralised debt obligations (CDOs) and contracts for difference (CFDs) bubble away out of sight, getting bigger and bigger as they did happily up until late 2007.
It’s not a problem, until suddenly it is. The artifice is exposed as unsustainable and the amount of money that has been sucked in is so huge that the whole edifice tumbles down.
The negative bond yield phenomenon has pretty well destroyed the ‘time value of money’ as the core of finance theory.
As Hong Kong-based Macquarie strategist Viktor Shvets wrote recently: “This has serious consequences.”
“[The] destruction of the cost of money not only interferes with credit cycles but also keeps ‘zombies’ alive … it encourages speculation and discourages productive investment,” Mr Shvets said.
“It spurs a race to the bottom with ‘beggar thy neighbour’ strategies, as nations compete to maximise returns from an ever-declining utility of debt.
“As long as monetary policies dominate, inequalities will continue widening. Eventually most societies will simply blow up,” was Mr Shvets’ disturbing endgame.
Sovereign bonds traditionally provide the bedrock investments and risk are priced off. When that crumbles, everything gets thrown out of whack.
JP Morgan’s Nikolaos Panigirtzoglou says the asset allocation of big investors like pension funds and insurance companies — who are obliged to buy massive licks of sovereign bonds — are being damaged by the negative rates, and things will get worse if the universe of negatively yielding bonds expands much further.
“Will negative rates force pension funds and insurance companies or other investors that dislike negative rates to move to equities?” Mr Panigirtzoglou asked.
“Or will pension funds and insurance companies hoover everything with positive yields in the fixed-income space, including alternatives such as private debt, and avoid equity asset classes?”
There are ways to make money on negative yields.
Play pass the parcel, selling the bond for a higher price as the yield sinks lower. This has a limited lifespan and is very dangerous when the music stops.
Some sophisticated traders can borrow at one of the yield curve and lend at the other, picking up a few basis points profit along the way. Trades can be carried across currencies, again picking up a few points of margin here and there.
Superficially, governments issuing negative should be laughing.
Germany, for instance, is being handsomely subsidised for decades to come by investors prepared to pay around a 0.5 per cent premium for the privilege of buying bonds. Normally those investors would expect a fairly solid, virtually risk-free profit.
The only problem is Germany is not laughing; it is in recession and there’s no sign the easy money is being recycled back into the economy.
The big end of town is lapping it up too. Banks are the exception, with their “borrow short, lend long” margins being squeezed.
“The main beneficiaries of negative rates have been large corporates, which have seen a collapse to their interest expense, as well as private equity companies that are able to lever by even more than in previous cycles to amplify their profits,” Mr Panigirtzoglou said.
… and the losers
So far, the losers are relatively contained and, predictably, at the small end of town.
Mr Panigirtzoglou said the squeeze on pension and superannuation funds, as well as insurers, has seen benefits reduced, and/or demands for contributions increased.
“The overall impact is that lower yields can induce households to save even more for the future,” he said.
“[There’s also] more income and wealth inequality as some households and small businesses fail to benefit or are even hurt from negative rates.”
Mr Panigirtzoglou argues while there may have been some positive impacts initially, keeping rates in very negative territory for prolonged periods, or diving them deeper into negative territory, could unleash more unintended consequences than benefits.
“[Increasingly] negative rates are viewed more as a policy mistake rather than stimulus and create a sense of an abnormal and uncertain environment that damages not only banks, but also consumer and business confidence,” he said
“This sense of abnormality and uncertainty likely makes businesses and consumers less rather than more keen to spend, and banks more rather than less averse to taking risk and extending credit to the real economy.”
But by far the most alarming problem is likely to be, just as it was in the lead-up to the GFC, risk was mispriced and a vast amount of capital was shuffled around looking for more substantial returns.
The bets got bigger and then, boom, it was all gone.
Despite a veritable bunting of red warning flags on display, the markets thought Friday was as good a day as any to get back to buying risk.
Inverted yield curves? Whatever. Chinese industrial output hitting a 17-year low? Not a worry. Trade war? So what? European companies slipping into a earnings recession? Priced it in. Germany in an actual recession? Yawn.
The S&P500 rose by 1.5 per cent in the closing session, but still ended in the red for the week. It was a similar story in Europe.
The ASX has had an ugly time of late, losing almost 3 per cent for the week and down more than 6 per cent since its record high late last month.
Markets on Friday’s close:
- ASX SPI 200 futures +0.6pc at 6,395; ASX 200 (Friday’s close) flat at 6,405
- AUD: 67.8 US cents; 61.1 euro cents; 55.8 British pence; 72.1 Japanese yen; $NZ1.05
- US: Dow Jones +1.2pc at 25,886; S&P500 +1.4pc at 2,889; NASDAQ +1.7pc at 7,896
- Europe: FTSE +0.7pc at 7,117; DAX +1.3pc at 11,563; EuroStoxx50 +1.3pc at 3,329
- Commodities: Brent oil +0.7pc at $US58.64/barrel; Gold -0.6pc at $US1,514/ounce; Iron ore $US91.50/tonne
The first takes on the ASX results season so far range from “puzzling” to “messy”.
Discretionary retailers, such as JB Hi-Fi and Super Retail Group, have delivered some of the most upbeat surprises, oblivious to talk of a retailing recession in the commentary from NAB’s business survey and the South African owners of the David Jones chain.
In contrast, a couple of their listed landlords, GPT and Vicinity Centres (owners of the sprawling Chadstone complex), were muttering darkly about challenging conditions.
The banks kept on their mantra about ‘intense mortgage market competition’ — a euphemism for no-one’s borrowing — while real estate portal REA talked about buyer interest in its site bouncing back.
Brokers JP Morgan said with about a third of the stock it covers having dropped results, an underwhelming 18 per cent of companies have beaten expectations, while 25 per cent have fallen short.
Only 9 per cent have seen their earnings forecasts upgraded.
There’s a barrage of results this week, including BHP, Bluescope, Qantas and Medibank Private.
With around a third of full year profits unveiled, more than 60pc of companies have reported higher earnings in 2019 compared to 2018. (Supplied: AMP Capital)
Quiet week ahead
Data-wise it is a fairly quiet week.
A collection of purchasing manager surveys (PMIs) is expected to show the pulse of the world’s industrial heartland continues to slow.
The world’s most powerful central bankers have their annual get together in the backblocks of Wyoming.
Host and Federal Reserve chair Jerome Powell speaks on Friday, while the RBA’s Philip Lowe steps up to the lectern on Saturday.
The G7 leaders are heading to France’s sunny south west at Biarritz for a three-day summit.
Could this be just the stage for new British PM Boris Johnson to finally tell the world what’s going on with his Brexit? Whatever the case, it could be entertaining.
|Company results||Bunnings Property Trust, Beach Petroleum, Bluescope, Lend Lease, NIB|
|Company results||BHP, Charter Hall, Estia Health, Oil Search, Platinum, Seek, Sonic Healthcare, Tassal, Virtus, Western Areas|
|RBA minutes||Insights into the August meeting where rates were left on hold|
|Company results||A2 Milk, Bapcorp, Brambles, Carsales, Crown, Domino’s, Iluka, Nearmap, St Barbara, Stockland, Reject Shop, Worley Parsons, Wisetech|
|Skilled vacancies||A forward looking measure of the labour market|
|Company results||Bingo, Cocal Cola Amatil, Coles, Flight Centre, Lovisa, Mineral Resources, Medibank Private, Nine, Origin, Perpetual, Qantas, Qube, S32, Scentre, Santos, Seven West Media, Webjet|
|Manufacturing survey||Aug: Markit/CBA flash PMI|
|Company results||Automotive Holdings Group, Ardent Leisure, Alumina, Goodman Group, Orocobre, Sims Metal|
|EU: Inflation||Jul: Still stuck around 1pc|
|US/CH: Trade||Deadline for extending temporary reprieve for an ban on exports to Huawei|
|US: FOMC minutes||Minutes from the August meeting where the Fed cut rates. Looking for hints of more cuts to come|
|US: Existing home sales||Jul: Could rebound from a soft previous month|
|US: Central bankers’ summit||Annual 3-day get together of the big central bankers at Jackson Hole, Wyoming, hosted by Fed chair Jerome Powell|
|US, EU, JP: Manufacturing surveys||Aug: European PMI expected to contract again, while US activity still expanding, but only just. Japan has been contracting for quite some time|
|US: New home sales||Jul: Tipped to rise|