How to look for a port in a monetary storm

And so the good ship Central Bank sails deeper into uncharted waters. A mere one week after denying such measures would be required, Bank of Japan Governor Haruhiko Kuroda late last month oversaw a cut in Japanese interest rates from 0.1% to minus 0.1%. 

This leaves Japan in the same company as Sweden, Denmark and Switzerland, all of whom already charge banks for the privilege of parking their cash with their respective monetary authorities and customers for the chance to own a current account.

Stock markets jumped in the hope fresh monetary stimulus would drag the world out of its slough of disinflationary (or even deflationary) despond but there is a risk this is no more than the triumph of hope over expectation.

Investors need to remember that:

• Japanese interest rates have been below 1% since 1994
• Japan has intervened several times in the currency markets to weaken the yen, in an attempt to boost exports
• Japan has been experimenting on and off with Quantitative Easing since 2001
• Japan’s Nikkei 225 index still trades at less than half of its 1989 peak
• The yield on 10-year Japanese Government Bonds (JGBs) stand at a new all-time low, once more tormenting sellers of an asset class nicknamed “the widow-maker” for its ability to confound the bears

Source: Bank of Japan, Thomson Reuters Datastream
NOTE: Past performance is not a guide to future performance and some investments need to
be held for the long term.

Japan is therefore the country to which no-one Western central banker wants to go, as its record in creating inflation and casting off the legacy of debt-fuelled property and stock market bubble is one of failure. Yet the West is dutifully trying the same policies.

Perhaps one day central banks will prevail, fuelling growth and inflation using electronic money created out of thin air. Stock prices would like to think so and advisers and clients need to consider their equity exposure in this light. 

But the relentless grind lower in bond prices would suggest someone is not so sure. 

If Western interest rates turn lower – not higher – even the meagre 1.56% yield on UK 10-year Government bonds will look good, especially if inflation stays at zero. 

This will leave investors to mull over just how well balanced are their portfolios. In this scenario fixed income and cash could trump equities even after a 30-year bull run. 

This may sound bizarre. But then so do negative interest rates in Japan; an 82-month run of record low borrowing costs in the UK; three rounds of QE in the UK and US and two in Europe; and a Federal Reserve that is starting to cop flak for a policy error after squeezing its headline interest up by a tiny 25 basis points (0.25%). 

Central bank blitz

The idea is simple: 

• If banks are charged to park their cash, they will choose to lend it instead, and seek a positive return
• If consumers are charged to park their cash, they will choose to spend it, or invest it, either boosting economic activity or creating a wealth effect as asset prices rise.

The problem is both arguments increasingly look like tosh. 

Banks cannot – will not – lend if the regulator keeps demanding that they hold more capital, or if they are unable to find borrowers keen to take on more liabilities than they already have, in a world that has more debt now than it did in 2007.

Investors may not feel like buying more on tick and they are not guaranteed to dump cash from their portfolios either. In certain circumstances taking a guaranteed 0.1% loss on cash might look like a better option than buying a stock or index that the investor thinks is overvalued and about to drop like a rock. 

Thrown a curve ball

Equally, buying a decent-quality sovereign bond with anything like a positive yield might seem tempting relative to negative returns on cash. This might be particularly the case, for the short term at least, if current bond market signals mean a recession is coming.

For the moment, the yield curve is flattening – or in other words, the yield difference between short-dated and long-dated Government bonds is shrinking. Long-dated bonds offer a higher coupon to compensate holders for the greater risk involved, as the interest payments are more back-end loaded and the return of principal further away, so there is more chance for something to go wrong.

However, the yield gap tends to close ahead of recessions. This is because the market prices in interest rate cuts by central banks, as they respond to the potential downturn, and this means investors buy bonds with higher coupons. This in turn forces those bonds’ prices up and yields down. Sometimes the yield curve inverts, as short-dated bonds begin to pay higher coupons (or offer higher yields at least) than longer-dated ones.

It is going to be awfully hard for the yield curve to invert in the US, UK, Japan or Europe, when central bank QE has tended to focus at the short-end and has clamped rates here down to near zero. But a flattening curve looks an even more ominous sign in those circumstances.

The charts below illustrate the falling yields on 2- and 10-year Government Gilts in the UK and 2- and 10-year Treasury bonds in the US, to illustrate the point.

UK 2- and 10—year Gilt yields

Source: Thomson Reuters Datastream
NOTE: Past performance is not a guide to future performance and some investments need
to be held for the long term.

US 2- and 10—year Treasury yields

Source: Thomson Reuters Datastream
NOTE: Past performance is not a guide to future performance and some investments need
to be held for the long term.

Put another way, this next chart shows that the gap between 2 and 10-year Government paper on both sides of the Atlantic is shrinking, especially in the USA.

Shrinking spreads between 2 and 10-year US and UK government bonds is suggestive of a possible recession

Source: Thomson Reuters Datastream
NOTE: Past performance is not a guide to future performance and some investments need
to be held for the long term.

Same old repeats

This is why the US Federal Reserve now faces questions about whether it was right to raise interest rates in December. If a recession is coming, the timing was hardly ideal.

This means the Fed may face the same dilemma as the central banks of Sweden, Denmark, Canada, New Zealand, Australia and even the European Union.

All have tried to raise interest rates since 2009. All have had to recant and take them down back to whence they came – and then lower still.

Early interest rate risers all had to reverse course

Source: Thomson Reuters Datastream

NOTE: Past performance is not a guide to future performance and some investments need
to be held for the long term.

Japan has found itself in this situation on several occasions since 1994. And this is why bears of Japanese bonds have come unstuck for the last 26 years and any repeat of Tokyo’s experiences could confound sceptics of fixed-income in the West.

Granted, a 1.56% yield on a UK ten-year Gilt looks very pawky, but inflation is still subdued and the true value of bonds lies not with nominal yields but real, inflation-adjusted ones.

The charts below show the real yield on UK and US 10-year paper.

Real yield on US 10-year Treasuries is above its post-1997 average

Source: Thomson Reuters Datastream

NOTE: Past performance is not a guide to future performance and some investments need
to be held for the long term.

Real yield on UK 10-year Gilts is marginally below its post-1997 average

Source: Thomson Reuters Datastream
NOTE: Past performance is not a guide to future performance and some investments need to
be held for the long term.

We only have inflation figures for December. The UK real, inflation-adjusted yield is 1.3% and the US equivalent the same. Both are below their averages of the last 20 or 25 years to suggest there is little value on offer – unless the world turns Japanese, weighed down by debt and poor demographics, not to mention the equally deflationary forces of the dollar and the internet. 

Bears of government bonds will point to Japan and argue central banks will not rest until they have stoked inflation.

Bulls of government bonds will point to Japan and argue it has been trying for 25 years to do so without success and that the UK, US and Europe have been at it for a mere seven. They may also add that real yields went an awful lot lower than they are now during the deflationary scares of 2008 and 2011.

Russ Mould

AJ Bell Investment Director