Column

DON’T WEEP FOR BONDS

The end of the great bond bull market is a sign of global recovery

DONALD COXE October 6 2003
Column

DON’T WEEP FOR BONDS

The end of the great bond bull market is a sign of global recovery

DONALD COXE October 6 2003

DON’T WEEP FOR BONDS

Column

The end of the great bond bull market is a sign of global recovery

DONALD COXE

THE GREAT bond bull market is over. From September 1981 to June 2003, the industrial world experienced a majestic bull market in bonds, driven by the collapse in long U.S. treasury bond yields from 15.75 per cent to 4.5 per cent. (When yields go down, bond prices go up.) In scale and duration, it was the golden age for bond investors. Yes, there were brief, brutal bear markets within that long period of decline in interest rates, notably 1987 and 1994. But they were temporary unpleasantries—the financial equivalent of rude belches in church-

serving merely to disconcert the participants, but not to alter the process.

What was at work those past two decades was sustained disinflation. Although bond markets react to short-term influences, such as central bank moves, their basic price trend is driven by changes in inflation. Period.

For example, interest rates plunged during the Reagan era, despite huge fiscal deficits and an economic boom. But because that administration’s policies on deregulation, tax-cutting, slashing non-defence spending and keeping the gutsy Paul Volcker as Fed chairman were fundamentally disinflationary, interest rates declined sharply and bonds boomed.

Bulls, whether of the bovine or bourse variety, are destined to die eventually. What made this bull nearly unique in financial annals was his ability to scamper in the sunlit uplands of the market whether the economy was weak or strong. He would rest for a while when the Fed was tightening, but just to regain his strength.

His final gallop came this spring amid the most widespread talk of deflation risk since the Depression. With Japan and China in outright deflation, Federal Reserve Board chairman Alan Greenspan mused aloud and often about that threat to the U.S. Result: investors rushed to bonds, with special emphasis on those issued by the industrial nations running the worst fiscal deficits. Ten-year Japanese government bond yields plunged to a submicroscopic 0.41 per cent at a time when their 10-year U.S. counterparts were touching a 40-year low of 3.15 per cent.

Since then, bonds have been beaten up so badly that some observers are proclaim-

ing the Death of the Bull and the Birth of the Bear. JGB yields have trebled, and U.S. 10year yields are up by roughly one-third. For holders of long-term bonds, perhaps the best interpretation of the summer bond selloff is that the bull became a steer. (Sudden steerdom is a painful and undignified experience for bulls of all kinds.) That means we have seen (or are now seeing) the bottom for home mortgage rates—certainly in the U.S. and, with lags, across the rest of the industrial world. It explains why most bond mutual funds have been disappointing investments this year.

So what makes this run-up in bond yields the sign of the end of an era?

First, the evidence grows weekly that a globally synchronized economic recovery has begun. If so, it will take years to unfold

fully, and interest rates will inevitably rebound from their 40-year (or longer) lows. These record-low bond yields, properly priced for a time investors feared the onset of a deflationary recession, are mispriced when global credit demand rises strongly year by year—and central banks worldwide switch from easing to squeezing.

Second, commodities are in a new bull market, and it also looks to be long-lived. Commodities (led by gold, oil and gas) started rallying during 2001, but they had been so beaten down in a two-decade bear market that had begun with a Triple Waterfall

WE HAVE seen (or are now seeing) the bottom for home mortgage rates, certainly in the U.S. and, with lags, across the rest of the industrialized world

Crash that few observers saw those increases as anything but “dead cat bounces.” (Triple Waterfalls, which are mentioned frequently in this space, are long-term collapses of some kind of financial asset; the process takes more than a decade, interrupted by brief “sucker” rallies in which emotional investors believe the good times are going to return. Nasdaq is currently undergoing such a delusion.) Having completed their crash, commodities are, I believe, in a new bull market.

Commodities, which are classic inflation hedges, trade in opposite fashion to bonds. If the Bond Bull is actually dead, then a Commodity Bull must have already been born, even if his birth has not been certified by the high priests of economics.

The onset of a long-term bond bear market does not mean interest rates are headed sharply higher soon. Global liquidity had been growing so strongly that there is lots of money to buy bonds and mortgages. As for U.S. treasury bonds, the central banks of Japan, China and Korea have been buying billions of dollars’ worth per week to hold down their currencies’ values in the exchange markets. That strategic buying drives down bond yields. For now.

Nevertheless, if by next spring the Japanese and Korean economic recoveries are still accelerating, and Europe has joined them, and commodity prices are still rising, then interest rates will move to higher plateaus as a prelude to moving to much higher levels. People who did not refinance their long-term borrowing will look back on this summer with anger—at themselves. Conversely, people with money to invest in bonds will be experiencing the novel pleasure of being offered attractive interest rates on their savings.

And the bond bull’s demise will be proclaimed at last by financial pathologists. M

Donald Coxe is chairman of Harris Investment Management in Chicago and of Toronto-based Jones Heward Investments. dcoxe@macleans.ca