A safe place to hide – inflation and the bond markets

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Macro Letter – No 91 – 16-02-2018

A safe place to hide – inflation and the bond markets

  • US bond yields have risen from historic lows, they should rise further, they may not
  • The Federal Reserve is beginning to reduce its balance sheet other CBs continue QE
  • US bonds may still be a safe haven but a hawkish Fed makes short duration vulnerable
  • Short dated UK Gilts make be a safe place to hide, come the correction in stocks

US Bonds

I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody – James Carville 1993

Back in the May 1981 US official interest rates hit 20% for the third time in 14 months, the yield on US 10yr Treasury Bond yields lagged somewhat and only reached their zenith in September of that year, at 15.82%. In those days the 30yr Bond was the global bellwether for fixed income securities; its yield high was only 15.20%, the US yield curve was inverted and America languished in the depths of a deep recession.

More than a decade later in 1993 James Carville, then advisor to President Bill Clinton, was still in awe of the power of the bond market. But is that still the case today? Back then, inflation was the genie which had escaped from the bottle with the demise of the Bretton Woods agreement. Meanwhile, Paul Volker, then Chairman of the Federal Reserve was putting into practice what William McChesney Martin, one of his predecessors, had only talked about, namely taking away the punch bowl. Here, for those who are unfamiliar with the speech, is an extract; it was delivered, by Martin, to the New York Bankers Association on 19th October 1955:-

If we fail to apply the brakes sufficiently and in time, of course, we shall go over the cliff. If businessmen, bankers, your contemporaries in the business and financial world, stay on the sidelines, concerned only with making profits, letting the Government bear all of the responsibility and the burden of guidance of the economy, we shall surely fail. … In the field of monetary and credit policy, precautionary action to prevent inflationary excesses is bound to have some onerous effects–if it did not it would be ineffective and futile. Those who have the task of making such policy don’t expect you to applaud. The Federal Reserve, as one writer put it, after the recent increase in the discount rate, is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up.

Back in the October 1955 the Discount rate was 2.30% and the 10yr yield was 2.88%. The economy had just emerged from a recession and would not embark on its next downturn until mid-1957.

Today the US yield curve is also unusually flat, especially by comparison with the inflationary era of the 1970’s, 1980’s and 1990’s. In some ways, however, (barring the inflationary blip in 1951-52) it looks similar to the 1950’s. Here is a chart showing the 10yr yield (blue – LHS) and US inflation (dotted – RHS):-

US Inflation and 10yr bond yield 1950 to 1973

Source: Trading Economics

I believe that in order to protect the asset markets (by which I mean, principally, stocks and real estate) the Federal Reserve (charged as it is with the twin, but not mutually exclusive, objectives of full-employment and stable prices) may decide to focus on economic growth and domestic harmony at the expense of a modicum of, above target, inflation. When Fed Chairman, Martin, talked of removing the punch bowl back in 1955, inflation had already subsided from nearly 10% – mild deflation was actually working its way through the US economy.

Central Bank balance sheets

Today there are several profound differences with the 1950’s, not least, the percentage of the US bond market which is held by Central Banks. As the chart below shows, Central Banks balance sheet expansion continues, at least, at the global level: it now stands at $14.6trn:-


Source: Haver Analytics, Yardeni Research

Like the Fed, the BoJ and ECB have been purchasing their own obligations, by contrast the PBoC’s modus operandi is rather different. The largest holders of US public debt (principally T-Bonds and T-Bills) are foreign institutions. Here is the breakdown as at the end of 2016:-


Source: US Treasury

As of November 2017 China has the largest holding of US debt – US$1.2trn (a combination of the PBoC and state owned enterprises), followed by Japan -US$1.1trn, made up of both private and public pension fund investments. It is not in the interests of China or Japan to allow a collapse in the US bond market, nor is it in the interests of the US government; their ability borrow at historically low yields during the last few years has not encouraged the national debt to decline, nor the budget to balance.

Bond Markets in Europe and Japan

The BoJ continues its policy of yield curve control – targeting a 10bp yield on 10yr JGBs. Its balance sheet now stands at US$4.8trn, slightly behind the ECB and PBoC which are vying for supremacy mustering US$5.5trn apiece. Thanks to the persistence of the BoJ, JGB yields have remained between zero and 10bp since November 2016. As of December 2017 the BoJ owned 46.2% of the total issuance. The ECB, by contrast, holds a mere 19.2% of Eurozone debt.

Another feature of the Eurozone bond market, during the last couple of years, has been the continued convergence in yields between the core and periphery. The chart below shows the evolution of the yield of 10yr Greek Government Bonds (LHS) and German Bunds (RHS). The spread is now at almost its lowest level ever. This may be a reflection of the improved performance of the Greek economy but it is more likely to be driven by fixed income investors continued quest for yield:-

Germany vs Greece 10yr yields

Source: Trading Economics

By contrast with Greece (where yields have fallen) and Germany (where they are on the rise) 10yr Italian BTPs and Spanish Bonos have remained broadly unchanged, whilst French OATs have seen yields rise in sympathy with Germany. Hopes of a Eurobond backed by the EU, to replace the obligations of peripheral nation states, whilst vehemently denied in official circles, appears to remain high.

Japanese and European economic growth, which has surprised on the upside over the past year, needs to prove itself more than purely cyclical. Both regions are reliant on the relative strength of US the economic recovery, together with the continued structural expansion of China and India. The jury is out on whether either Japan or the EU can achieve economic terminal velocity without strong export markets for their goods and services.

The one country in the European area which is behaving differently is the UK; yields have risen but, it stands apart from the rest of the Eurozone; UK Gilts dance to a different tune. Uncertainty about Brexit caused Sterling to decline, especially against the Euro, import prices rose in response, pushing inflation higher. 10yr Gilt yields bottomed in August 2016 at 50bp. Since then they have risen to 1.64% – this is still some distance from the highs of January 2014 when they tested 3.09%. 2yr Gilts are different matter, with a current yield of 71bp they are 63bp from their lows but just 22bp away from the 2014 high of 93bp.

Conclusions and Investment Opportunities

From a personal investment perspective, I have been out of the bond markets since 2013. My reasoning (which proved expensive) was that the real-yields on the majority of markets was already extremely negative and the notional yields were uncomfortably close to zero. Of course these markets went much, much further than I had anticipated. Now I am tempted by the idea of reallocating, despite yields being lower than they were when I exited previously. Inflation in the US is 2.1%, in the Euro Area it is 1.3% whilst in Japan it is still just 1%.

As a defensive investment one should look for short duration bonds, but in the US this brings the investor into conflict with the hawkish policy stance of the Fed; that is, what my friend Ben Hunt of Epsilon Theory dubs, the Inflation Narrative. For a contrary view this Kansas City Fed paper may be of interest – Has the Anchoring of Inflation Expectations Changed in the United States during the Past Decade?

In Japan yields are still too near the zero bound to be enticing. In Germany you need to need to go all the way out to 6yr maturity Bunds before you receive a positive yield. There is an alternative to consider – 2yr Gilts:-

united-kingdom-2-year-note-yield - 5yr

Source: Trading Economics

UK inflation is running at 3% – that puts it well above the BoE target of 2%. Rate increases are anticipated. 2yr Gilt yields have recently followed the course steered by the US and Germany, taking out the highs last seen in December 2015, however, if (although I really mean when) a substantial stock market correction occurs, 2yr Gilt yields have the attraction of being near the top of their five year range – unlike 2yr Schatz which are nearer the bottom of theirs. 2yr Gilts will benefit from a slowdown in Europe and any uncertainty surrounding Brexit. The BoE will be caught between the need to quell inflation and the needs of the economy as a whole. 2yr Gilts also offer the best roll-down on the UK yield curve. The 1yr maturity yields 49bp, whilst the 3yr yields 83bp.

With inflation fears are on the rise, especially in the US and UK, 2yr Gilts make for an uncomfortable investment today, however, they are a serious contender as a safe place to hide, come the real stock market correction.

A very French revolt


Macro Letter – No 13 – 06-06-2014

A very French revolt


Sur le Pont d’Avignon

L‘on y danse, l’on y danse

Sur le Pont d’Avignon

L’on y danse tous en rond

Last month I spent a few days helping a friend with his business in Avignon. This was a brilliant opportunity to canvass the views of the non-metropolitan French in respect of the current government and the state of the French economy. During my career I have worked closely with Parisian bankers and asset managers. Somewhat like London, Paris is “another country” which happens to be situated in the middle of France. In the provinces they believe in “rendre la vie plus simple”– life rendered easier.

The city of Avignon is close to the tourist heartland of Provence but it is also very much a commercial centre for a wider agricultural region. The above picture is of the famous Pont Saint-Benezet bridge across the Rhone; the bridge collapsed in 1644 and is now a tourist attraction. It is better suited to dancing today than it was at the time of the 15th century childrens’ song, but, as the home of the Pope from 1309 until 1377, the city has a long history as a tourist attraction.

Old Avignon is a beautiful city and a world heritage site. As one wanders around the walled centre,interieur du murs, filled with shops, cafes and restaurants, one is reminded of the French esteem for “La Bonne Vie”.  Exterior du murs it is a different story. Large housing projects and, often, poorly maintained properties, bare witness to the, predominantly North African, diaspora who work in agriculture or the service industries, or, in many instances, do not work at all. Avignon is a city of contrasts but it offers a unique window into “real France”.  During my visit I spoke to four of the city’s residents:-

  1. a French engineer who works for a large utility company.
  2. a French economist working for local government helping immigrant workers find local jobs
  3. an ex-pat American carpenter who has lived and worked in the region since the 1960’s
  4. a French national who works in the real-estate and tourist industry

None of them were overwhelmed by the performance of Francois Hollande’s PS (socialist party) government, but, to my surprise, none were surprised by his “about-turn” on economic policy.

Francois Hollande was elected in 2012 on a mandate to “tax and spend” but soon achieved a volte-face. The current policy calls for Eur 50bln of spending cuts over the next three years. These cuts will be concentrated on health and welfare. Public sector wages are to be frozen – though I have no doubt many public sector workers will be promoted to higher pay grades. The headline figure is somewhat misleading since the policy package also incorporates reductions in taxes for employers amounting to some Eur 30bln. Nonetheless, it is unlikely that any other French political party could have achieved as much austerity.

The French electorate seem unimpressed by these policies as witnessed by the rising fortunes of the Front National in the European Elections last month. The rightward swing has been widely reported but I doubt the “protest vote” – which has been seen across the EU – will have much impact except to slow the process of federalisation.  Steen Jakobsen – Saxo bank had this to say following the outcome of the vote:-

Across Europe, EU-sceptic voters gained ground, but it could be in vain as the overall majority of the old guard: Conservative, Liberals, Greens and Social Democrat’s still carry 70 percent of the mandates.

…The 751 members of the EU Parliament operate through coalitions of interest across countries and sometimes political standpoint. The final date for submitting a coalition is June 23, and a “coalition” has to be at least 25 members from seven different nations. Here the protest votes can play vital role. The Europe-sceptic vote is divided. The risk is that, similar to the Occupy movement in the US, all lack of common goal, except those of a negative nature, allows the majority get away with ignoring what clearly is a call from the voters to the politicians that Europe is too far away from the daily life of its 500 million citizens.

…The EU “economic police” will be tested. France and Spain is already in violation of budget deficits for 2014 and 2015. The so called “recovery” is actually a stabilisation, not recovery. In history, unions, even primitive ones, fail when economic times turns negative.

The condition of French government finances is not rosy: public debt to GDP is running at 57%. Tax to GDP, at 57%, is the highest in Europe. Meanwhile unemployment is stuck in double digits. The economy has stalled; Q1 GDP was zero and the IMF revised forecast for 2014 is down to 1%. Unsurprisingly, foreign investment into France declined -0.9% during the first quarter.


Returning to Avignon the issues which most concerned all the “locals” I interviewed were immigration and the standard of living: or perhaps I should say “Quality of Life”. As in many developed countries, immigrants will accept lower pay and take on more menial tasks than the indigenous population. As long as there are higher paid, higher skilled employment opportunities this process frees up scare resources to be employed in productivity enhancing roles. When those opportunities do not exist a country’s standard of living suffers: younger and older workers bare the brunt. In France this effect has been softened by encouraging younger people to study longer, often at the tax payers’ expense. Older workers have been encouraged to retire earlier, again, at the tax payers’ expense.

A recent post from Scott Sumner – How to think about Francemakes some economic comparisons with the USA: –

…So, here are some [2008] ratios of France to the United State:-

GDP per capita: 0.731

GDP per hour worked: 0.988

Employment as a share of population: 0.837

Hours per worker: 0.884

So French workers are roughly as productive as US workers. But fewer Frenchmen and women are working, and when they work, they work fewer hours.

…The bottom line is that France is a society with the same level of technology and productivity as the US, but one that has made different choices about retirement and leisure. Vive la difference!

Professor Sumner observes what von Mises called “Human Action”. He goes on to make some observations about employment protection: –

France has a wide range of policies that reduce aggregate supply:

1.  High taxes and benefits, which create high MTRs.

2.  High minimum wages and restrictions on firing workers.

What should we expect from these “bad” supply-side policies?  I’d say we should expect less work effort at almost every single margin. Earlier retirements, more students staying longer in college, longer vacations, and a higher unemployment rate.

France has always had a reputation for employment protection but overall it is not dramatically different from its larger European neighbour as the OECD – Employment Outlook 2013  reveals in their latest employment protection rankings. Whilst France is above the OECD average (Page 78 – Figure 2.1) it is not that far above Germany.

TheInternational Labour Office –An anatomy of the French labour market – January 2013gives a detailed account employment trends. The rise of temporary labour has been as prevalent in France as in many other countries despite, or perhaps as a result of, its rigid employment laws. The ILO describes this as a Two-tier system which creates a more stringent protective framework for workers on long-term contracts and very limited protection for workers on short-term contracts. According to their report the legislative policies in countries such as France and Spain has led to higher job turnover. Since the 1990’s France has seen a 70% to 90% increase in short-term employment. This trend has accelerated since the Great Recession.

As French government spending falls, the opportunities for longer-term employment, especially for the young and older worker, will be reduced. The ILO continue: –

The share of temporary jobs in the private sector is far higher among young workers aged between 15 and 24 years old than among prime-age workers (25-50) and senior workers (over 50): 39.9 per cent vs. 10.7 per cent and 7.0 per cent in 2010. It is also higher for women (15.2 per cent) than for men (9.1 per cent).

When viewed through the lens of “employment opportunity” the French protest vote at the European Elections is not that surprising. The table below shows the wage inequality between permanent and temporary contracts across Europe, France comes third, behind the Netherlands and Sweden on this measure: –

Wage premium for permanent contracts for 15 European countries.
Sweden 44.7
Netherlands 35.4
France 28.9
Luxembourg 27.6
Germany 26.6
Italy 24.1
Greece 20.2
Austria 20.1
Finland 19
Ireland 17.8
Denmark 17.7
Spain 16.9
Portugal 15.8
Belgium 13.9
United Kingdom 6.5

Source: Boeri (2011)

Impact on the financial markets

But what does all this mean for the French financial markets? To judge by the recent performance of the CAC40 and 10yr OATs, not much.


CAC40 - source - yahoo finance

Source: Yahoo finance

The new highs have been achieved on low volume which may indicate a lack of conviction. What is clear is that the EU election results were anticipated. What is less clear is whether the market reaction is a sign of approval at the “protest” or apathy. It is clear that the financial markets are more concerned about ECB policy. May 2014 EU inflation was +0.5% vs an ECB target of +2%. The small cut in the refinance rate this week and the introduction of negative interest rates on deposits held at the ECB are hardly sufficient to offset the disinflationary forces of the EZ rebalancing which has been on-going since the great recession. The end of “monetary sterilisation” and new targeted LTROs, together with the proposal for the ECB to purchase certain ABS, however, looks like the beginning of something more substantial. OMT is still in the arsenal but has yet to be deployed.

10 yr OATs reflect a similar story: –

OAT 10yr yield

Source: Investing.com 

The all-time low yield was set in April 2013 at 1.64% but, with French growth apparently slowing, yields remain wedded to those of German Bunds. The 10 year spread has continued to converge this year from 65bp on 15th January to around 40 bp today.

French Real-Estate may also be influencing other asset classes. According to a recent OECD report French residential property is still overvalued despite the declines of the past couple of years. On a Price to Rent measure the OECD estimate values to be 35% higher than the long run average. On a Price to Income basis the overvaluation is only 32%. It is worth noting that interest rates are at historically low levels so these overvaluations are not entirely surprising. France is not alone in its overvaluation as the table from Deutsche Bank (using earlier OECD data) shows: –

Global House Prices - OECD + Deutsche bank - February 2014

Source: Deutsche Bank and OECD

In their March 2014 Global House Price Index report, Frank Knight commented that residential property in France and Spain was still languishing. However, in comparison with March 2012 prices were down only 1.4% in France compared to 4% in Spain and 9.3% in Greece.

If historically low interest rates cannot stimulate demand for Real-Estate then asset managers would do well to allocate to a more attractive asset class. With OAT yields nearing historic lows the CAC40 appears to be benefitting by default; it trades on a P/E of 26 times. The UK, with the strongest growth forecast in Europe, is trading at 33 times (FTSE) whilst the DAX trades on a P/E of 22.


The French Revolt at the EU elections is principally a protest against the immigration policies of the French administration. The main concern of the average French voter is long-term employment and quality of life. The policies of Brussels, which reinforce those of the French administration, are seen as contrary to the interests of the French people in respect of immigration but this does not mean that the French people are anti-EU.

French financial markets have paid little heed to the EU election results. The actions of the ECB are of much greater importance in the near-term. The longer-term implications of the gains for the Front National will be tested at the Senate Elections in September this year, but, given the large socialist majority last time, any swing to the Front National will be a further “protest”. The real test will be at the presidential elections – scheduled for 2017.

Low interest rates from the ECB look set to continue. The central bank has now begun to utilise some of the unconventional tools at their disposal to transmit longer-term liquidity to the non-financial economy. OAT yields should remain low in expectation of the implementation of these more aggressive policies. They will also be supported internally if Hollande succeeds with his austerity package. French property prices are likely to remain subdued and may weaken further if the economy continues to stall. French stocks will therefore continue to benefit, both from international and domestic capital flows, but, at their current valuations, they will reflect the direction of international markets led by the US and, within Europe, by the UK and Germany.