A momentous event in financial markets – and it’s only January

Published in The Sunday Times on January 22nd 2023.

In his 2009 annual letter to shareholders Warren Buffett wrote: “When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary.” Buffett was right about the first two. But financial historians won’t time-stamp the peak of the bond bubble for more than a decade after Buffett’s letter. 

We are only weeks into the new year and there has been a momentous event in financial markets which will be written about for decades hence.

Bond market bubble 

The global stock of bonds where investors received sub-zero yields peaked at $18.4 trillion in late 2020, according to Bloomberg’s Global Aggregate Index of the debt. That will most likely be seen as the peak of the bubble.

That pile of negative-yielding debt vanished in the first week of January. At least for now, every global government bond in the world has a flat to positive yield. Without fear of hyperbole, this is an extraordinary moment.

I think we are going to look back on the last nine years of negative interest rates (sub-zero yields first appeared in 2014) with incredulity. The consequences of this era will likely last for many years.

Negative yielding debt

Investors’ willingness to buy debt that guaranteed a loss if held to maturity was one of the most incredible quirks in financial markets of the last decade. And that’s before making any adjustment for inflation, which would have accelerated those losses. 

Investors’ idea of what Central Banks’ and Governments (particularly those with their own currencies) could achieve were catapulted higher in the last few years. The reach-for-yield implications of the monetary (and fiscal) experiment we have been through need to be considered.

Reaching for yield and chasing after performance were things a conscientious investor would never stoop to do. In the age of negative rates those transgressions against good practice became almost compulsory. That game has changed. 

A ten-year Irish bond today is yielding 2.8%. I’d fall short of describing this as compelling value, but it hasn’t been this high since 2014. To the extent that demand for other assets was being driven (at least in part) by the TINA philosophy – there is no alternative. This poses a challenge for future investment decision making now that there are alternatives. 

Zero interest rate policy

The anchor in any valuation process is the risk-free rate. The value of any project or asset is judged relative to what can be earned without taking any risk.  To the extent that any valuation assessment was being done at all, with that anchor in negative territory it distorted the process. 

Those distortions manifested themselves in cryptocurrencies, non-fungible tokens, and meme stocks to name but a few. There has been lots of head scratching going on in traditional investment firms over the last few years, but it also impacted mainstream assets.

The unwinding of zero interest policy (ZIRP) has been well-flagged for some time. There was a well-reasoned expectation that it would expose severe weaknesses in assets with questionable (or non-existent) fundamentals. But the real fear was the contagion risk – the impact it might have on the broader market. The dotcom mania of 1999/2000 seemed like a reasonable and proximate comparison, a phase during which the broader stock market got absolutely hosed.

Comparisons with the mania of 1999/2000, I think were wide of the mark. In this cycle, pockets of madness seemed to have unwound without severe contagion risk. Notwithstanding, global stock markets have declined between 15-20% in 2022 (more in some cases) and valuation multiples have dropped even more as earnings have so far, held up well. 

Yes, there was lots of junk trading on valuations that seemed - to borrow a phrase from the early part of this Century - not only to be discounting a rosy future but discounting the hereafter. 

Prudence has gone unrewarded

Similarly, there were many good companies that were trading on magnificent valuations. The unwinding of ZIRP doesn’t obliterate these businesses. Microsoft Corp., and Amazon.com Inc. were priced for perfection at the market peak back in 2000. Both were, and still are, great companies. But buyers at the top in 1999 had to wait over a decade to break even.

Tesla shareholders beware. I don’t know if Tesla is a modern-day example of Microsoft or Amazon - that sort of insight is beyond my pay grade, but I do know that the sort of patience and fortitude needed to find out is in short supply.
 
The disappearance of negative yielding bonds was a major event in financial markets this month. Prudence has gone unrewarded for several years. We should celebrate its return. 
 

Gary Connolly is Investment Director at Davy. He can be contacted at gary.connolly@davy.ie or on twitter @gconno1.