As equity markets hedge their bets over a double-dip recession, bond markets cast a pall over the economic outlook. Tomas Hirst investigates which is the likely winner - inflation or deflation
W?hile equity markets are giving investors few signs as to whether bulls or bears are winning, bond markets are providing a more worrying forecast.Yield spreads between investment grade and high yield bonds have been a serious topic of concern in recent weeks. The yield on American investment grade bonds briefly reached 3.74% on August 24, according to the Bank of America Merrill Lynch US Corporate Master index. This was the lowest figure recorded by the index since it was launched in October 1986.While that figure has recovered somewhat at the time of writing, much of the uptick can be attributed to a sharp fall in trading volumes. The volume of bond sales over August was 42% higher than during the same period last year following a record-breaking July, which saw more than $90 billion (£58 billion) in trades.Most of these transactions, however, were done in the first half of the month before investors appeared to lose interest, leading to muted activity towards the end of the month. To some commentators this suggested a growing borrower fatigue but Purna Bhudia, a credit analyst at LV= Asset Management, says it is more likely a consequence of large investors balking at the rapid price increases.
"The bond spreads suggest large players are still wary of putting risk on to the table but the problem in investment grade markets is lack of supply," she says. "It's not a liquidity problem, sophisticated investors simply want to get the right price for these assets." (article continues below)
While investment grade has followed Treasury yields on their downwars trajectory, the high yield market has so far remained more resistant to the downward pressure. The average yield on American high yield bonds was 8.63% as at September 3, keeping the spread over government bonds above 600 basis points. In a further sign of market stress Bloomberg data showed no junk-rated debt had been sold from August 20 to the end of the month.
The disjuncture is worthy of examination as it indicates that bond markets are ahead of volatile equity markets in their assessment of the economic outlook and in particular in their view of the inflation/deflation debate.
Over the past 12 months the FTSE 100 index has returned 15.95% to investors, while the mid-cap focused FTSE 250 index has done even better, returning 20.11%. The American market has performed similarly well with the S&P 500 index rising 10.20% in dollar terms over that period.
The rally that took hold last year has seemingly continued, although with the addition of significant volatility. This is despite poor macroeconomic data showing a faltering recovery in America, where home sales figures came in much weaker than expected, and the commerce department announcing a sharp downward revision in GDP growth for the second quarter from an annualised rate of 2.4% to 1.6%.
British growth was also muted, with output increasing by 1.2% in the second quarter, according to the Office for National Statistics. This is coupled with signs that credit conditions may be worsening after figures from the Bank of England showed that the number of mortgages approved for British home buyers was barely changed in July at 48,722 while net mortgage lending growth fell to just £86m over the month from a downwardly revised £518m in June.
The apparent buoyancy of equity markets suggests that fears of a double-dip recession have not yet become consensus. With the FTSE 250 rallying almost 7% over the past two weeks alone it seems the bulls could be keeping the bears in check, at least for the moment.
Bond markets, in contrast, have been showing strong signals that the more pessimistic outlook is being deemed more likely by fixed income investors.
"What I can see is that there is plenty of liquidity ready to be invested, but they're all running to the safe haven of government bonds," says Vincenzo Albano, a fixed income analyst at Reuters Insider. "The outlook for corporates is poor as demand is shrinking and banks are unwilling to extend credit as a consequence. There is no expectation in bond markets of an imminent bounce in inflation."
Huge amounts of money moving into investment grade and government debt over July and the first half of August stand testament to the conviction that bonds will provide a buffer as the corporate recovery stumbles. The scale of moves has been so large that Albano says most of the necessary funding for this year has already been done, meaning the traditionally busy month of September is likely to be quiet.
In this light the argument that the drop in trading volumes is simply suggestive of buyer fatigue after the splurge through July and early August seems only a partial explanation. A general shift into fixed income should have seen yields fall across the board, which has not been the case with high yield. There is also plenty of liquidity waiting on the sidelines ready to be invested as opportunities present themselves, belying such a thesis.
Similarly, if excessive price was a major factor investors would surely be put off buying into government bonds trading at near record low yields as well as investment grade. This does not appear to be the case as American 10-year Treasuries are still trading at 2.625% and the German bund yield continues to fall, dropping to 2.28% last week. British 10-year gilts are not too far behind, paying a coupon of 3.06%.
Ian Spreadbury, the manager of Fidelity's Strategic Bond fund, says the situation is sufficiently serious to mean that the new norm for British gilts is likely to drop from its 5% average over the past decade to 3%. Similarly, American Treasury yields are likely to remain at depressed levels over the medium term.
A far more interesting analysis, hinted at by Albano, is that supply constraints are becoming the driving factor behind bond price movements. The problem has two dimensions. First, simple supply/demand dynamics mean that excess demand should drive up prices and force yields down, which is a part of the process we have been seeing.
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The second, however, and more recent phenomenon is that the price has become so high that yields have been driven below a level most sophisticated investors would traditionally buy into.
That investors are willing to accept such a small payout for holding government and investment grade debt is suggestive that fear is overwhelmingly the driving factor behind recent price movements. This fear, however, has a definite source in the spectre of the deflation beast.
If, as expected by the Bank of England (BoE) Monetary Policy Committee, inflation drops sharply to reflect demand contraction and a slowing of business activity then there is a real danger of the country entering a period of deflation.
In an article entitled Seven Faces of "The Peril", James Bullard, the president of the Federal Reserve Bank of St Louis, argues that Japan may not be an anomaly in falling into a persistent deflationary cycle.
The central concept is that policymakers who follow an active Taylor-type monetary policy rule, whereby when inflation is above the target rate a central bank should counteract this with a more-than-proportional increase its base rate, previously argued that this provides only one steady state. This is one where the policymaker no longer wants to raise or lower interest rates, and the private sector expects the level of interest to remain constant.
What Bullard points out, following on from the work of Jess Benhabib, Stephanie Schmitt-Grohé and Martín Uribe, is that there are two such steady states. The "targeted" state, where inflation is modestly positive and the interest rate stable and the unintended state where the interest rate has been reduced to zero and inflation is marginally negative. As interest rates can be moved no lower in the latter case, monetary policy effectively becomes passive and a country becomes trapped in a stable and self-propagating spiral of deflation, as in the case of Japan.
While these fears are still some way from being realised, the threat of a substantial period of deflation is one that both the Federal Reserve and the BoE are taking seriously. Mervyn King, the BoE governor, said last month that the Bank would "stand ready to expand "¦ the extent of monetary stimulus" to counter the threat, while in America the Fed has begun to buy long-dated Treasuries in what has been termed "QE-lite".
Under these conditions even the modest yields offered by government bonds would appear attractive in case the efforts by central banks to ward off deflation fail. This might help to explain why interest in the asset class has been so resilient. In July £ Corporate Bond was the second most popular sector taking net inflows totalling £259.4m over the month.
The consequence of this sudden surge has placed a huge amount of power into the hands of investment grade borrowers. Not only are issues quickly subscribed but, Bhudia says, companies can easily tap dollar and euro markets to gain financing, shrinking the available pool of sterling-denominated debt.
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On the high yield side the picture is more complicated. Fear over the sustainability of the global recovery has done few favours for risk assets so the yields need to remain high to compensate investors for taking on the additional liability.
"There are signs that banks don't want to put risk back on the table and so for weaker credit I think there are will be concerns," Bhudia says.
Although it could be argued that large players such as pension funds might be forced up the risk spectrum in search of much needed income, risk aversion could prevent this money from reaching low-grade companies. With several developing countries having proven their ability to withstand and bounce back from a crisis, a lot of the money waiting to be invested is moving instead towards emerging market debt.
"I don't see pension funds being able to enter high-yield markets in any serious way with the possibility of a double dip still on the table," Albano says. "I think they are much more likely to move into second-tier sovereign debt."
As an example Albano points to the Philippines, which has five-year bonds yielding 5.5%. Interestingly, since June the yield on 10-year bonds from the country have fallen from more than 8% to 6.36% as at September 7, showing the scale of investment moving into the country.
Their popularity has already prompted the government of the Philippines to announce plans to sell peso bonds overseas for the first time to fund a record budget deficit this year. The issue is expected to be oversubscribed even though Moody's Investors Service rates the debt Ba3 and Standard & Poor's awards it a BB-.
Indonesia offers another insight as between 2003 and 2010 the yield on the country's 10-year bonds averaged 11.23%. It is currently 8.173% having fallen to a record low of 7.877% at the beginning of last month.
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With bank lending tightening and bond markets shunning risk, the list of potential investors in lower grade companies looks thin. Ironically, however, their saving grace could be the exact reverse of the reason why investors have been flocking to fixed income in recent months: inflation.
As America embarks on another round of quantitative easing and with King fresh from writing his third letter to the chancellor explaining why inflation remains above the 2% target, inflation fears are flourishing. Indeed, such is the conviction of some fund management groups that they are launching products that aim to take advantage of rising inflation.
Last week M&G Investments announced the launch of two inflation-linked funds, the UK Inflation-Linked and European Inflation-Linked Corporate Bond funds. While the group has said overcapacity and high unemployment should dampen inflation in the short term, the consequences of quantitative easing should exert themselves over the medium term, providing an inflationary surge.
As Jim Leaviss, the head of M&G's retail fixed interest team, says in a statement, the group is "building the fire engines in case there is a fire".
If inflation does suddenly pick up, people who have ploughed money into low-yielding paper may find themselves caught out. As inflation eats into the capital value many investors will be tempted to sell, causing further price depreciation, removing the haven status of the asset and leaving only the prospect of an extremely modest income.
"The willingness of monetary policy makers to act may provide a floor for inflation," says Spreadbury. "Indeed, quantitative easing is likely to get revisited if deflation pressures emerge [as they have nearly done in America]. All this leads me to believe the chances of a policy mistake over the long run are significant and that would not be good news for government bonds."
Investors in high yield will be buffered to a greater extent as the increased income will offer some relief from the price destruction. They will also be able to pick up government and investment grade debt at distressed prices, having avoided the stampede into them at their peak.
The downside is that to take advantage of this development, investors would have to reconcile themselves with increasing their exposure to risk in the face of weakening global economic growth and the potential of tightening credit conditions.
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