Inside investment: Debt – status quo anti
Despite political shocks, the issuers of ‘safe’ government debt will continue to have the upper hand over the bond vigilantes, and the great financial repression will continue.
Being awake at 4am is not usual for me. But when the US networks declared the state of Pennsylvania for Donald J Trump, the call of bed was finally too strong. It was over.
Momentarily the mind skipped to American friends from Allentown and Scranton who made it to Wall Street and were possibly starting or ending their election night vigil feeling, like me, slightly dazed.
Brexit was always too close to call and the crumbling blue wall in Pennsylvania and election of a reality TV star were surprising, but neither were really worth losing too much sleep over.
One of the many strengths of the US constitution and the wisdom of the Founding Fathers is that POTUS may be the greatest title in the world, but the executive branch of government does not generally get much done.
Italy’s December referendum on needed constitutional reform may provide yet more proof that popular opinion is so anti everything vaguely sensible that anyone opposing anything wins. The new status quo is to be anti.
For financial markets, Trump was a bit of an event. Credit spreads barely moved, but US equities have rallied a little and some bond markets have sold off at the long end, though they were doing that anyway.
Every strategist is now talking about the reflation trade and fiscal largesse, which is broadly good news for equities, the dollar, Treasury Inflation-Protected Securities (Tips) and readers who follow this column.
But the bond vigilantes should beware. The pain trade over the next few years will be any expectation of a normalization of yields to the good old days of inflation plus a couple of per cent, depending on perceived sovereign risk.
That will not happen.
Fiscal stimulus does imply more debt and less need for monetary intervention via quantitative easing and other measures. The US Federal Reserve will almost certainly raise rates in December.
Quantitative easing is no longer regarded as unconventional policy – it is the default setting
However, even the wilder manifestations of the political fringe will not be enough to alter the dynamics of a market that increasingly has little to do with outdated notions of debt sustainability.
McKinsey, in the latest update to its study on global debt and deleveraging since the onset of the financial crisis in 2007, shows that no big economy has decreased its overall debt-to-GDP ratio.
The global stock of debt has increased by $57 trillion, far outpacing global growth.
Government debt has grown the fastest, with a compound annual growth rate since 2007 of 9.3%. There has not been much in the way of austerity or good housekeeping. Yet, yields have ground inexorably lower.
There is too much debt to be serviced for yields to rise back to the old normal.
This reality will continue to drive the behaviour of governments and central banks.
Quantitative easing is no longer regarded as unconventional policy, it is the default setting. The knee-jerk reaction of the Bank of England to Brexit, further expanding its balance sheet, was unsurprising but not necessary as weaker sterling and resilient consumer confidence have buoyed the economy.
The Fed continues to maintain its bloated balance sheet, and there are not even murmurs about when the policy will be changed or unwound. Instead, most Fed speakers talk of more QE as an option should the economy weaken.
The European Central Bank was late to the QE party, but is more than making up for lost time. The Bank of Japan has admitted the inevitable and, after trying QE infinitum, it has thrown in the towel and is now financing fiscal policy with monetary policy.
Central banks are far from being the only buyers of government debt in spite of historic low yields and high levels of indebtedness.
The BoE has found it hard to get its hands on the bonds it wants. The financial system is in a deadly embrace with sovereign debtors because regulation forces them to hold an ever-larger number of these ‘risk-free’ assets on their balance sheets.
Pension funds are increasingly turning to matching assets and liabilities by buying nominal and inflation-linked government bonds, because absurd accounting rules force them to treat long-term investments as if they were due today.
The UK Debt Management Office could triple its issuance of long-dated inflation-linked gilts in the absolute certainty there would be demand.
Bond investors need to face up to this.
Political shocks might drive short-term price movements, but in the long-term, structural factors will keep yields low.
The best way to default is to pretend you have not done so and inflate away the debt.
Though no one will say it out loud, that will continue to define policy.
Financial repression is here to stay, regardless of who is in power.