View from Crystal Bay: A 17 Trillion Dollar Bet on Bonds

Investors aren’t limited to only investing in the S&P 500 and the Dow Jones Industrial Average. Every week we share the market trends we are following. We are interested in whether the trends in those markets are continuing or if they are experiencing a temporary or complete reversal.

When we identify trends, we are only concerned about the price data and what it says about any given market. We don’t need to know why a trend has formed to invest, but our human nature wants to understand what is driving them. Each week we try to offer some perspective on what we think the most substantial moves are and what critical drivers are behind them. Here we look at what is going in our globally diversified, non-correlated Crystal Bay Ubitrend strategy.

Last week’s continuing trends:

  • Nikkei Index
  • Russel 2000
  • China A-Shares
  • New Zealand Dollar
  • FAANG+ Index

Last week’s reversing trends:

  • Japanese Government Bonds
  • Gasoil
  • Chinese Renminbi
  • Japanese Yen
  • Natural Gas

What we are taking note of: 

The collapse in bond yields reached two new landmarks in November. The stock of negative-yielding debt passed $17 trillion, beating the previous record reached in August 2019. And for the first time in history, China issued a bond with a negative coupon.

The negative-yielding Chinese government bond is an interesting development. It was denominated in euros, not the usual funding currency for China, which has historically preferred raising money in US dollars. But the low yields have proved to be enticing, both for China’s government as the issuer and for European investors as the buyers. 

China is the only one of the major economies paying positive real yields on its debt. After inflation, real yields on one-year notes range from -2.5% in Germany to -2.0% in the US and Canada, -0.5% in Japan, and -0.3% in the UK. Standard economic theories predict that an economic recession accompanied by high unemployment should lead to a collapse in inflation. We haven’t seen that in this recession. The US personal consumption expenditure (PCE) inflation, the best measure of consumer inflation, remains stubbornly high at 1.71% as of October 2020, barely budging from the pre-pandemic level of 2.1% posted in January and February 2020.

Previous recessions, going back to the 1980s, have all been caused by a decline in demand triggered by Fed monetary tightening. The 2020 recession is a very different beast, with its roots in the collapse of supply due to pandemic closures. People have money; the middle class and the rich have been shielded from the downturn by generous Treasury handouts. They just don’t have enough options to spend it on. The usual distractions: restaurants, travel, nightlife, have been shut down or severely curtailed. Money is instead being spent on financial market speculation (casinos are closed) and home improvement.

Around the world, we’re seeing supply shortages. The most obvious ones are in soft commodities which have a short production cycle: grains, lumber, palm oil, rubber. But the lost year of 2020 will impact the production of everything. Prices will have to go up to allocate scarce goods to ever hungry consumers.

The combination of low yields and high inflation is hell for bond buyers. The last time we saw a similar setup, in the early 1970s, government bonds earned the nickname “Certificates of Confiscation.” There are few guarantees in the financial markets, but one thing you can hang your hat on is that if you buy a bond with a 0% coupon in an environment of positive inflation, you’ll be poorer when the bond matures.

Pension plans, retirement accounts, and insurance companies that invest a large proportion of their customers’ money in bonds are setting up for a massive disappointment down the road. We’re witnessing the greatest financial bet of all time: that inflation will not come back within our lifetimes. $17 trillion is staked on it. If they’re wrong, millions of people will find their retirement to be a very different experience from what they hoped for.