Bond Vigilantes

With a less than satisfactory ‘I told you so’ look from Jim scant reward for my efforts in attending this year's Champions League Final in Athens, I’ve taken more heart from the continued data flow (click the chart to enlarge) supporting my view of higher interest rates for Europe. In addition, I experienced first hand some inflationary gouging by the Greek taxi drivers - a temporary, and unofficial, cartel imposed supplement of 20 Euros for all Liverpool fans for any journey.

April’s money supply data released earlier today by the European Central Bank showed a slight deceleration from March’s reading of 10.9% YOY growth to 10.7% YOY, though these figures needs to be put into context. At 10.7% the growth in money supply remains well above the 4.5% level that the ECB considers non-inflationary and remains one of the key measures they will use to gauge future inflation. M3 money supply has remained above this 4.5% non-inflationary level since early 2001 with no real sign of abating, despite seven rate increases since late 2005. Indeed the ECB is extremely concerned that this excessive liquidity will drive prices up, pushing inflation above the 2% annual target.

At last month's press conference, ECB President Trichet signalled a hike in June to 4% but since then, continued rises in oil prices, tight labour markets and strong capacity utilization data are likely to add further fuel to the fire. Indeed the futures market is already anticipating at least another hike to 4.25% by year end with ECB member Garganas stating today that they will keep their options “open” beyond June.

Whilst US rate cuts are looking less likely now - a long pause looks the best bet - I can't see what (besides perhaps a stock market crash?) can stop the ECB from continuing to "normalise" European monetary policy. I’ll continue to run a short duration (bearish) position in the European Corporate Bond Fund in the face of such compelling data.

A few of you will have heard of David Hillier, Barclays Capital's Chief Economist. Besides coming joint top of the 2006 league table of economic forecasters (David's been predicting more UK rate hikes than the market for some time, and been right), he has been fighting advanced prostate cancer since the end of 2002. According to the doctors he should be dead by now, but he's still with us, and getting ready to ride the first stage of the Tour de France in an amateur "cyclosportif" a week before the pro riders do it on July 7th. The route starts in Greenwich, and winds through the Kent countryside, through Tunbridge Wells, and ends up in Canterbury, 120 miles later. David and nearly 20 others, (possibly including myself - those of you who remember my epic Lands End to John O'Groats ride a couple of years ago when I failed to get out of Cornwall will be rightly sceptical), will be riding in aid of the Prostate Cancer Charity (David has already raised over £250,000 in previous efforts). If you'd like to support him, and help towards his target of £50,000, please visit David's website where you can donate online, and read more about his illness and the fact that he credits cycling, at least in part, for saving his life. Thanks in advance!

Sent by anonymous, 23 May 2007:

"As an IFA I am constantly reminded to adopt the principles of asset allocation and ensure that most clients have a spread of equities and bonds within client portfolios. However the outlook for bonds from most quarters is poor and many investors are suggesting that their bond allocation would be better off in cash where the capital value is secure and the yield much higher than gilt or bond funds.

What is your view and what advice could you give to IFAs struggling with this dilemma?"

First of all, thanks for the question. We want this blog to be interactive, and we're happy to receive any questions, comments or market thoughts readers might have.

Whilst we are, of course, forbidden to offer investment advice, we can share your pain. With the UK yield curve inverted (yields on longer dated bonds yielding below the Bank of England rate) you have to believe that the price of these longer dated assets will rally simply to match the return on cash. And once you've paid management fees the hurdle is even greater. With some of the internet banks offering rates of 6% (virtually risk free as the deposits are largely protect by the government) it's understandable that clients have found traditional corporate bond funds unattractive, especially if held outside a tax free ISA. As such we have seen that the most popular area for investors in our funds in recent months has been into money markets and other "cash plus" type products (including leveraged loans). These instruments pay a floating rate of return linked to base rates, plus a margin to reflect credit risk. So for example a Floating Rate Note (FRN) issued by AA rated Citibank might pay 3 month Libor (currently 5.78%) plus 9 bps, so 5.87% in total. A similar instrument issued by a sub-investment grade company like Saga Holidays might pay 8.28%, and in both cases if interest rates rise - as we expect them to - the returns will also increase. So if you agree with us, and expect higher interest rates, look for bond funds with high exposures to FRNs within their portfolios.

An alternative strategy would be to look at funds which can use the new UCITS3 wider powers; these funds may be able to take bearish views both on interest rates and on credit spreads, and thus can make positive returns even if bond markets are selling off. Richard Woolnough's M&G Optimal Income fund, which has the ability to express such bearish views, has seen positive returns since launch in December last year, outperforming the average high yield fund, money market fund, corporate bond fund and gilt fund (the latter two asset classes having had negative returns over the period).

A final thought would be to think about the purpose of a diversified asset allocation, and the point of bonds. None of us has perfect knowledge, and whilst the global economy feels lovely right now, we do worry that a US recession could be a possibility in 2008. In that circumstance - or indeed in a world where terrorism, bird flu, and oil shocks are possibilities - bonds may perform very strongly. I've been involved in the bond markets since 1992, and I think that it's true to say that fixed interest NEVER looks fantastically attractive! The yields available will always look meagre compared with "expected returns" on equities and other riskier assets - yet there have been many periods over those past 15 years when bonds have outperformed equities, sometimes significantly. Asset allocation models are there to help match the clients' assets to their expected liabilities. These liabilities almost certainly involve the provision of a fixed income on retirement, or an annuity purchase, and in these circumstances to buy anything other than bonds is taking a bet - a bet which many FTSE companies took when they bought shares for their pension funds rather than bonds, and one that went very wrong in 2001-2003 and resulted in the pension fund deficits that persist to this day in many cases.

This is not me being fantastically bullish on fixed interest - you can see from our fund positioning that we are short duration compared to our peers, and also underweight in credit risk. But as long as central banks keep inflation under control (and that will involve at least one more UK rate hike), the interest rate environment could be very different next year, and bonds could start to rally in anticipation of weaker growth. Ten year gilt yields have nearly reached 5.25% (having been at 4% at the start of 2006) - a level that's starting to look like good, if not compelling, value. But we think it will take a normalisation of the yield curve (with higher long dated bond yields than cash rates) before either we, or our clients, back up the trucks and go heavily overweight in the bond asset class. Sent by anonymous, 23 May 2007:

"As an IFA I am constantly reminded to adopt the principles of asset allocation and ensure that most clients have a spread of equities and bonds within client portfolios. However the outlook for bonds from most quarters is poor and many investors are suggesting that their bond allocation would be better off in cash where the capital value is secure and the yield much higher than gilt or bond funds.

What is your view and what advice could you give to IFAs struggling with this dilemma?"

First of all, thanks for the question. We want this blog to be interactive, and we're happy to receive any questions, comments or market thoughts readers might have.

Whilst we are, of course, forbidden to offer investment advice, we can share your pain. With the UK yield curve inverted (yields on longer dated bonds yielding below the Bank of England rate) you have to believe that the price of these longer dated assets will rally simply to match the return on cash. And once you've paid management fees the hurdle is even greater. With some of the internet banks offering rates of 6% (virtually risk free as the deposits are largely protect by the government) it's understandable that clients have found traditional corporate bond funds unattractive, especially if held outside a tax free ISA. As such we have seen that the most popular area for investors in our funds in recent months has been into money markets and other "cash plus" type products (including leveraged loans). These instruments pay a floating rate of return linked to base rates, plus a margin to reflect credit risk. So for example a Floating Rate Note (FRN) issued by AA rated Citibank might pay 3 month Libor (currently 5.78%) plus 9 bps, so 5.87% in total. A similar instrument issued by a sub-investment grade company like Saga Holidays might pay 8.28%, and in both cases if interest rates rise - as we expect them to - the returns will also increase. So if you agree with us, and expect higher interest rates, look for bond funds with high exposures to FRNs within their portfolios.

An alternative strategy would be to look at funds which can use the new UCITS3 wider powers; these funds may be able to take bearish views both on interest rates and on credit spreads, and thus can make positive returns even if bond markets are selling off. Richard Woolnough's M&G Optimal Income fund, which has the ability to express such bearish views, has seen positive returns since launch in December last year, outperforming the average high yield fund, money market fund, corporate bond fund and gilt fund (the latter two asset classes having had negative returns over the period).

A final thought would be to think about the purpose of a diversified asset allocation, and the point of bonds. None of us has perfect knowledge, and whilst the global economy feels lovely right now, we do worry that a US recession could be a possibility in 2008. In that circumstance - or indeed in a world where terrorism, bird flu, and oil shocks are possibilities - bonds may perform very strongly. I've been involved in the bond markets since 1992, and I think that it's true to say that fixed interest NEVER looks fantastically attractive! The yields available will always look meagre compared with "expected returns" on equities and other riskier assets - yet there have been many periods over those past 15 years when bonds have outperformed equities, sometimes significantly. Asset allocation models are there to help match the clients' assets to their expected liabilities. These liabilities almost certainly involve the provision of a fixed income on retirement, or an annuity purchase, and in these circumstances to buy anything other than bonds is taking a bet - a bet which many FTSE companies took when they bought shares for their pension funds rather than bonds, and one that went very wrong in 2001-2003 and resulted in the pension fund deficits that persist to this day in many cases.

This is not me being fantastically bullish on fixed interest - you can see from our fund positioning that we are short duration compared to our peers, and also underweight in credit risk. But as long as central banks keep inflation under control (and that will involve at least one more UK rate hike), the interest rate environment could be very different next year, and bonds could start to rally in anticipation of weaker growth. Ten year gilt yields have nearly reached 5.25% (having been at 4% at the start of 2006) - a level that's starting to look like good, if not compelling, value. But we think it will take a normalisation of the yield curve (with higher long dated bond yields than cash rates) before either we, or our clients, back up the trucks and go heavily overweight in the bond asset class.

We've talked a fair bit about the possibility of a significant US slowdown over the course of the next twelve months (see here). Now that we've cracked the dark arts of posting charts on our blog, I thought it's worth showing you the simple yield curve analysis that lies behind both Greenspan's, and the current Fed's, thinking. History shows us that when long term bond yields in the US fall below the Fed Funds rate, the US economy slips into recession within a year. The chart to the left (click on to enlarge) shows this happening in the early 1970s, mid 1970s, early 1980s, early 1990s, and in 2001 (marked as "Nearly Recession" on the chart - we didn't see negative GDP growth, but US recessions are "declared", like Port vintages rather than scientifically measured!). It's been a very accurate predictor of economic weakness, and the bad news is that we've seen an inversion in the yield curve for several months now, implying that there will be a recession next year.

Our next chart is less pessimistic though - it plots the "line of best fit" for the relationship between growth and the yield curve. On this measure you might expect a soft landing in the US next year, with annual GDP growth of perhaps 1%. This is still way below trend growth though (3-4%?), and as such an output gap is opening up - we have already had almost a year of sub-trend growth in the States. In my view this growing output gap is disinflationary (actual growth being below the potential of the economy), and helps explain why core US inflation data have been well behaved lately, and should remain subdued going forwards. This is better news for government bonds, which have been in a bear market.

Where we worry most is in the yield curve's predictive powers for credit spreads. Our third chart shows that BBB rated bonds (the lowest rated investment grade companies) are paying the lowest premium over government bonds for nearly 30 years. If we show the yield curve chart against this (and inverted) we can see that the historical relationship has broken down aggressively in the last couple of years. Given the yield curve is suggesting an economic slow down, we would expect credit spreads to have widened to reflect a riskier world and future higher default rates - but they haven't done so. The simple model might predict that corporate bond yields should be around 200 bps more than government bond yields, rather than just over 100 bps as they are right now. As a result we think lower rated corporate bonds are expensive, perhaps simply reflecting an excess of demand (for example from the CDO market) in a period when we feel monetary policy has been too loose. Our funds are defensive in terms of our credit exposure - the yield curve has a good predictive track record, and it feels right to draw in one's horns and take some chips off the table (to mix metaphors) at this time of the economic cycle.

Last week it was announced that the number of new UK mortgage approvals fell to 113k, resulting in much media speculation that the UK housing market is in danger of collapsing. I strongly disagree with this view and expect the UK housing market to remain buoyant over at least the next half year.

The image here (click to enlarge) shows the close correlation between mortgage approvals and UK house price growth. There is a lag of seven months between mortgage approvals and the rate of house price changes, so I've moved the mortgage approvals data forward by seven months so you can predict where house prices will be in seven months time. While mortgage approvals have fallen slightly, a level of 113k has historically corresponded to annual house price growth of over 15% seven months later.

Our bullish view on the UK housing market is enforced by this image (click to enlarge), which shows the RICS sales/stock ratio against UK house price changes. The sales/stock ratio is measured over a rolling three months and shows the number of estate agent sales divided by the number of unsold houses that estate agents have on their books. The sales/stock ratio is a measure of both demand and supply (mortgage approvals is only a demand measure), and the ratio is an even better predictor of UK house prices. Crucially, the sales/stock ratio is still rising and the current level suggests that annual UK house price growth will move from around 10% now to at least 15% in six months.

Looking forward, the key question is whether the slight fall in mortgage approvals is the beginning of a downward trend as in 2005 (when a sustained drop in mortgage approvals data very accurately predicted the sharp slowdown in the housing market and prompted the Bank of England to cut rates), or whether the recent fall in mortgage approvals is just a blip along the same lines as the beginning of 2006 (when mortgage approvals dropped from 119k to 107k but then rebounded). Based on historical correlations, mortgage approvals data below about 100k and sales/stocks of about 0.35 indicate that the housing market is slowing, but at the moment there is no evidence of this happening.

Indeed, UK house price growth is, if anything, accelerating. The London property market is extremely hot - figures from the Department of Communities and Local Government show that London prices rose 16.7% in the year to the end of February. Traditionally, London is at the epicentre of the UK housing market, and price gains (or losses) in London gradually ripple outwards. The only way to slow the housing market is hike rates.