Mind the gap! – May 21st 2013

In the 70’s, when I was cutting my teeth in investment management, we were in a bizarre world, which included the Sex Pistols and a phenomenon known as the reverse yield gap. For many years I pondered the use of the word “reverse” because as far as I was concerned the gap between bond (mostly in double figures) and equity yields (significantly lower) was just that; a yield gap. It had not occurred to me that at a much earlier and more rational time equities yielded more than bonds because they were more risky.

But the ‘70s saw the rise and rise of inflation which of course is anathema to bonds so yields went into orbit until Paul Volker, the last Fed Chairman who knew what he was about, put the genie back in the bottle by raising the Fed funds rate to 20% in 1981. 20%!!

Ten year Treasury yields were sub 4% in the early ‘60s and it was 50 years before the rate settled below that level again and the yield gap again became the norm, but for a whole new set of reasons. Volcker was followed by Greenspan who achieved a God like status; his every word was treated as the ultimate truth when it reality he hadn’t got a clue, but before we all worked that out the cult of central bank interference was embedded in the investment psyche.

Here was a man who called a market top in 1996 as irrational exuberance only for the S&P to double over the next four years. He also thought that Y2K was a huge threat and kept downward pressure on rates until mid-1999 when the aforementioned irrationality was gathering pace. His next mistake was not to lower the funds rate until December 2000, well after the top of the tech bubble and then drive it down to 1% by 2004 a move that begat the next bubble in property and the resulting CDS/CDO melt down.

Pushing the rate back over 5% didn’t stem the property surge and in 2006 he handed over to Bernanke who very quickly opined that the housing market was not in a bubble and that the proliferation of mortgage backed securities was never going to be an issue and we trust central bankers to run monetary policy with these sort of insights…BoE, ECB, BoJ are all in it together.

Since the Lehman bust they have struggled to get the economies going again and deliberately kept rates low in the belief that this will encourage borrowing and spur demand. It has failed to do either, but created yet another bubble, this time in the bond markets. The yield gap, should be telling us that bonds are less risky than equities, but with yields at all-time lows, that does not look to be the case.

The assumption to validate such low yields is that the central banks will keep up the money flow, but already the Fed has started to debate just when QE might stop and the latest suggestions are that it will be some time this year. Treasury, Gilt and Bund yields are now off their lows, and equities may just be getting the message that rapidly rising bond yields are not good for stock markets. Where does the risk off money go then??

When yields got down below 4% in 2008 we were saying much the same thing about bond valuations and then the conversation moved on to whether we were becoming Japanese and about to move towards eternal deflation. Now the Japanese want to become good inflationistas. They have got off to a good start with the “J” curve effect upping import costs. It remains to be seen whether increased export competitiveness actually translates into more exports. The yield on 10 year JGBs has gone from 0.3% to 0.9%; still under 1% for now but inflation is back on the menu. If they do manage to stoke it up they might want to revisit Volcker’s methods for getting it back down again. If you want a real shock put his 1981 Fed funds rate in your risk free return calculation and extrapolate just how “cheap” equities are….Mind the gap!