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The answer to "What's going to give the Fear Index a boost ?" was staring us in the face all along .... The threat of Thermonuclear War,...

August 11, 2017

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Politics and markets are always interlinked, right ? Here's a view that suggests that the bond market may be ignoring the new political order .....

August 7, 2018

 

 

ref :- "Bond investors must keep an eye on populist threat to low-inflation world" , Karen Ward of JP Morgan Asset Management, Markets Insight in the Financial Times

 

When you've been away for a bit and only able to follow things from a distance, it's always of interest to have a good look around to see what's changed, and indeed what remains the same. For example, the Turkey situation has deteriorated hugely from what was already a pretty dismal outlook ten days ago. On top of a general loss of faith in the independence of the central bank, and in the prospect of anybody taking the necessarily tough monetary policy decisions in defiance of President Erdogan, we can now throw in a bitter diplomatic spat with the United States over an American pastor being held by Turkish authorities on alleged spying charges. The resulting sanctions being imposed by the US (on a NATO ally, remember), will do nothing to help the dire current account and inflation crises facing Turkey. There are rumours of behind-the-scenes talks making headway, but the markets have been giving Mr Erdogan their view in unequivocal fashion : the Turkish Lira tumbled from below 4.90 to the dollar to above 5.40 at its weakest overnight, and 10yr bond yields have jumped 200 basis points in two weeks.

 

One thing that doesn't seem to change is that every time we go away, we return to Jamie Dimon  --   bond guru and boss of JP Morgan Chase   ---    voicing his expectations for much higher bond yields. A while ago, Mr Dimon was suggesting that an upward break of 10yr US Treasury yields through the 3.00% barrier signalled a sharp move to 4.00%. The forecast for higher bond yields (and lower prices) was a perfectly legitimate opinion then, just as it is now. As we've often discussed, strong growth, low unemployment and a jump in issuance of Treasury paper required to fund Mr Trump's tax cuts do make a strong case in support of Mr Dimon's directional view. There are counter arguments though, and since the 10yr yield has broken up through 3.00 no less than four times (including last week) before falling back again, one might have imagined Mr Dimon toning down the rhetoric.

 

Not a bit of it .... in fact, he's upped his call to imagining a 10yr Treasury yield of 5.00%. That's bold .... even some of those who buy into the continuing growth story do not see it lasting long enough from this already very advanced stage of the cycle to see yields that high. But fair play to Mr Dimon .... if you're as high profile as he is, and brave enough to make extreme calls likely to leave you right out on a limb if they go wrong, then perhaps you deserve a bit of credit.

 

Presumably, Mr Dimon is Karen Ward's ultimate boss so in a very superficial sense it's no surprise to learn that her article also sees threats to the long-term bull market in bonds. Rather than focus on cyclical economic forces however (booming economy overheated by fiscal stimulus put in place by the White House and Congress), she looks at how politics in the modern era  --  in other words, the trend towards populism  --  is unwinding all the DIS-inflationary factors that engineered the decades-long rally in bonds in the first place. Those factors would include :

 

1. The dismantling of trade union collective bargaining , led by Ronald Reagan and Margaret Thatcher, which allowed employers to hold down spiralling wage costs.

 

2. The move to more independent central banks and the consequence of monetary policies being focused on pegging inflation rather than boosting the electoral chances of politicians.

 

3. The tech revolution .... reducing both manufacturing costs and allowing consumers to source goods more cheaply online.

 

4. China .... whose entry into the World Trade Organisation effectively doubled the goods-producing sector controlled (well, theoretically at least) by that body.

 

5. The march of globalization, which meant that short-term individual "cost-shocks" to an economy were less likely to develop into a wider concern over inflation.

 

All these disinflationary factors had a fundamental effect on fixed-income markets. The very fact that the income is FIXED means that bonds are vulnerable to inflation as it eats into future returns, and so a fall in inflationary angst means that investors need less insulation against that risk. Hence, falling yields and a long-term bull market in bonds.

 

So why might today's political trends which have manifested themselves in stunning success for populist movements reverse these structural factors ?

 

The backlash against liberal elites since the financial crisis is largely a function of working people in Western societies becoming worried about jobs and providing for their families, problems that those elites were failing to recognise (in the eyes of some). While politicians were talking of the benefits of migration, outsourcing and automation, large slices of working populations could only see them as threats to their job security and ability to earn a fair wage. The widespread depth of such feelings was something that the mainstream political establishments utterly failed to appreciate , and it resulted in repeated electoral shocks. Financial markets were for the most part no better in factoring in the possibilities of such game-changing political developments, and the suggestion is that many still haven't got their heads around how populist politics might have some very unwelcome implications for bond markets.

 

Go back to the list of factors behind low inflation above ..... Electoral success means that what had been the discontented and borderline extreme rantings of small but vociferous minorities are now becoming government policy. Those newly-elected governments on the left will assume the role once filled by trade unions, their support boosted by promises of higher minimum wages and general incomes, and of job guarantees and generous pensions. Rest assured, most economists will be tearing their hair out at the lack of mathematical rigour behind such promises, but few could argue that such policies at the very least must be inflationary.

 

Central bank independence ? Already the highest profile populist of them all, Donald Trump, has been giving the Fed a hard time about raising rates (a debate that he is supposed to stay out of). It's worth reiterating that politicians like low rate regimes because it makes their debts easier to service and makes them more popular with Joe Public  --  until the wheels fall off, that is.

 

Technology ? Surely no one's suggesting that that's going to come to an end ? Well no ..... but populism could put the brakes on by taxing profits to an extent not seen before, thereby stifling growth.

 

China and the WTO ? President Trump and his prospective trade war demonstrate the vulnerability of what we have become used to to new political thinking. If you think that buying an imported item at a cheaper price to the locally-produced equivalent is inherently "wrong", and if you believe that buying those cheaper imports is such an economic threat that it amounts to a matter of national security, then you're presumably not going to be too bothered about upticks in inflation.

 

What we're witnessing now could be the start of a whole new ball game. In which case investors will have to banish thoughts of the warm, cosy, low-inflation environment that they've known for so long, and tailor their decisions to something very different .... which of course means bad news for the bond market and higher yields all round. Mind you, as even Mr Dimon would have to concede, we've been here before and for one reason or another it hasn't happened yet.

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