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Bond Market Screaming Depression

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http://www.telegraph.co.uk/finance/newsbysector/epic/ftse100/7878184/Mind-the-gap-why-the-bond-markets-are-signalling-a-depression.html

Mind the gap: why the bond markets are signalling a depression

Something potentially momentous has happened in financial markets in the past two months.

By Jeremy Warner

Published: 6:00AM BST 08 Jul 2010

Virtually unnoticed, the yield on long dated pan-European sovereign debt has slipped below that on equities. So what, you might say; that's what happens when shares go down and bonds go up. But in fact this reversal in the traditional relationship between bonds and equities is an extraordinarily unusual event. It's happened only three times in the past 50 years. Alarmingly, all three of those occasions have been in the past decade. What are markets trying to tell us?

There are two ways of looking at the phenomenon. Either it is an aberration, and therefore a buy signal for stock markets, or much more worrying, it marks the final death knell for Europe's 60-year love affair with equities, and therefore the start of a generalised retreat from risk that will see the economy stagnate or worse for perhaps decades to come.

I'm an optimist, so I tend towards the former view, but even I would concede that the situation looks ominous; a double-dip recession in either the US or Europe continues to seem unlikely, yet the odds are shortening fast. If the economy starts to contract again, there are plainly highly negative implications for corporate earnings.

But before exploring these two scenarios in more detail, first some historical context. Rewind in time to 1947 and something equally momentous occurred. That was the year in which the Imperial Tobacco pension fund was advised to switch all its assets out of gilts and into equities. Thus was born, for the UK at least, "the cult of equity".

It took a while for the new religion to take hold, but by the late 1950s, it had become the prevailing investment orthodoxy. Over time, it was figured, equities would always outperform bonds because unlike bonds, both dividends and capital would appreciate with inflation and economic growth. As a consequence, the yield on shares has been lower than on bonds pretty much ever since. Investors have become very comfortable with that relationship and tend to regard anything else as abnormal.

On any longer term perspective, however, it's not abnormal at all. Up until 1959, the reverse had been true. For most of the last century and much of the previous one too, equities had consistently yielded more than gilts to compensate for their supposedly higher risk profile. It was only after 1945 that modern portfolio management turned this idea on its head by postulating that higher risk investments would also deliver higher rates of return over time.

What seems abnormal today was in fact the prevailing normality for more than 100 years. How likely is it that we are returning to that bygone age? To believe that we are you have to think there's a depression coming, or at least a prolonged deflationary period.

The thing that makes equities relatively attractive against bonds is inflation. Inflation destroys the value of government bonds as surely as outright default. Conversely, long bond yields of even as little as 3pc begin to look attractive in an environment where prices are falling. For companies, on the other hand, the real burden of costs and debt would rise, with potentially devastating consequences for earnings. But it is not just fear of deflation which is destroying the cult of equity. There are structural reasons too. The UK stock market used to be largely owned by its UK corporate and institutional constituents through their pension funds and savings products. As these funds mature and diversify into more risk averse investment strategies, that relationship is being progressively broken. UK equities have been dumped and government bonds hoarded.

These structural factors are perhaps as important in explaining why the yield gap has narrowed so markedly in the past 10 years as the economic fundamentals. Nor should we omit the regulators from blame. Having cocked up so spectacularly over the banks, they are now more risk averse than ever. Across the piste they demand safety first investment strategies.

Yet on both the two previous occasions where the relationship between bond and equity yields actually reversed – March 2003 and late 2008 – it proved not to be the end of the world for equities, but actually marked the bottom of the trough and therefore a buying opportunity. We are once more in a similar period of extreme risk aversion. Is this another such buying opportunity, or is it this time really the beginning of the end?

The following answer may sound like a bit of a cop-out, but anyone can stick their finger in the air and pretty uninstructive it is too. What does seem clear is that the old rules of investment no longer apply.

Instead, we've moved into a much more multi-layered world where broad brush generalisations about particular asset classes have ceased to carry much meaning. As we have learned, not all sovereign debt is the same; some sovereign bonds are more equal than others. Investors have learned to calibrate sovereign risk in a way that would have been unthinkable just three years ago.

Similarly with equities, where obvious winners and losers are beginning to emerge from the wreckage of the financial crisis. Companies with high exposure to fast growing emerging markets are viewed in a very different light to those wholly reliant on advanced economy consumption or government spending. A German bund is self evidently not just a safer, but in every respect, a better investment wager than a Greek bank. But there is a good reason why Standard Chartered, with its strong Asian presence, is more highly prized than even the most credit worthy of government debt.

Few economists think either Europe or the US are about to enter a double dip. The market signal sent by the equity/bond crossover suggests otherwise. Are the economists again lagging the reality? Willem Buiter, chief economist at Citi, won't entirely rule out a double dip, but as he points out, markets are driven as much by fear and phobia as economic fundamentals and are therefore as frequently wrong about things as the economists. They are like noisy school children, he says; you should pay attention but not take them too seriously.

One thing we know about children that they are frequently capable of startling original perception, and right now they seem to be telling us that something fundamental has changed. The old dynamic is all mixed up. Whatever world it is they are signalling, we won't be going back to the old, pre-crisis one any time soon.

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What's the opposite of "full steam ahead" ?

"man the lifeboats! bankers and mps first".

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"man the lifeboats! bankers and mps first".

:lol:

The comments on that article read like something from HPC too. Good to see others suggesting that the current banking system is crap.

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Hard astern. Icebergs ahead.

Titanic is too simple an analogy. This maybe more appropriate for the financial crisis:

The course that is first to be held is to the north/north-east until you be found under 61 degrees and a half; and then to take great heed lest you fall upon the Island of Ireland for fear of the harm that may happen unto you upon that coast. Then, parting from those islands and doubling the Cape in 61 degrees and a half, you shall run west/south-west until you be found under 58 degrees; and from thence to the south-west to the height of 53 degrees; and then to the south/south-west, making to the Cape Finisterre, and so to procure your entrance into the Groin or to Ferrol, or to any other port of coast of Galicia

The course plotted was complex, backed up by theory ... and failed because the pilots (central bankers) were unable to measure their positions and didn't understand the North Atlantic drift (bond market).

Can you guess what disaster it is?

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  • 140 Brexit, House prices and Summer 2020

    1. 1. Including the effects Brexit, where do you think average UK house prices will be relative to now in June 2020?


      • down 5% +
      • down 2.5%
      • Even
      • up 2.5%
      • up 5%



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