Dear Fellow Investors and Friends
Today is Thursday, the 28th of September. It is the 271st day of the year; 94 days remain until the end of the year. This week, we had the holiest day on the Jewish calendar, Yom Kippur.
On this day 50 years ago, history’s biggest oil price shock happened as several different Arab nations invaded Israel and sparked the chain of events that led to a massive oil embargo. This led to “stagflation” — inflation and economic stagnation — in the developed world for much of the next decade. As I have said to anyone who would listen (and even, sometimes, those who don’t want to), history never rhymes but repeats.
Also, today is the day my wife Amanda and I plan to ride Mont Ventoux, one of the most famous climbs of the Tour de France. This implies I am on holiday, which further implies a shorter letter than normal.
Quote of the day
“If you think deflation is a fact of life, you clearly haven’t paid attention to history.”
The US 10-year Treasury bond price is widely regarded as the most important market price in the world. It is the ultimate risk-free asset, off which all other assets are priced. As bond geeks know, the price of bonds is inversely related to their yields.
So, when yields reach new highs, as they currently do, prices are reaching new lows. And if the price of the world’s risk-free asset collapses, then all other assets are in danger. That might or might not lie in our future. Risk assets seem under pressure now, but it may be short-lived.
Who knows? History is littered with people who were wrong in their short-term forecasts.
What is more valuable to think about is the longer-term implications if the 40-year downtrend of interest rates globally has started to reverse. US interest rates peaked in the (northern hemisphere) autumn of 1981 at a yield of 15,82%. At the time, they were called “certificates of confiscation”, as anyone who had invested in them over the previous 30 years had lost money!
Investors’ allocations to bonds were at a minimum.
Today, investors are record-long bonds after a 40-year bull market, which ended with 10-year yields in the USA at 0,5% in August 2020. Just this week, Bloomberg reported that “the iShares 20 Plus Year Treasury Bond ETF (ticker: TLT) gathered $750 million in assets, bringing its net inflow during the year-to-date to $16.3 billion, equivalent to nearly half of the vehicle’s $38.2 billion in total assets.”
After 40 years of declining interest rates, investors seem hard-wired to buy bonds after an uptick in yields. Two generations of investors, or almost everyone managing money today, have made money buying bonds.
Why should it be different this time?
Markets love throwing curveballs at investors, and the current set-up in the ultimate global risk-free asset does not look healthy. Lots of supply is coming to the market – due to lower tax receipts and higher spending, the US government deficit is expected to be $2 trillion this year, or over 7% of GDP. This shortfall must be funded by selling government bonds to a market where demand is faltering. US investors are full-up, and China may prefer gold over their historic go-to asset: US government bonds.
This over-supply of bonds could be in place for an extended period of time due to the funding requirement for the fight against climate change, tax incentives for onshoring, the fight against inequality, support for Ukraine in the war against Russia or any other crisis “du jour.”
One of the important functions of market prices is to match supply with demand – and if supply is too high for the level of demand, and the higher level of supply is sustained, prices need to decline to a level where demand picks up. And this decline could be in place for an extended period of time.
It is not impossible that we are in the throes of a structural change in the direction of interest rates.
If this is the case – and that is a very big if – everything we “know” to be true regarding how asset prices behave can be thrown out of the window. Especially everything we “know” since the GFC of 2008, when Central Banks globally started reducing interest rates to ultra-low levels.
Old dogs will have to learn new tricks.