You might be getting sick of Donald Trump by now, so I apologise in advance.
But there’s still a lot of serious investment fallout being generated by his election, so we can’t really ignore it.
If it’s any consolation, I’ll not be going into any of pseudo-scientific chat about why he’s been elected, or issuing any despairing ‘dark night of the soul’ missives.
Let’s keep it all about the investing. More specifically, let’s keep it about the most important thing in the financial world right now – bond yields…
Why you really need to keep an eye on bond yields
The election of Donald Trump has sent shockwaves across global markets: developed world equities have rocketed and commodities have soared on hopes for growth, but fears of protectionism have sent most emerging markets lower. Gold is down as the dollar has surged.
However, the most important thing to keep an eye on is something that many equity-obssessed investors tend to ignore – bond yields. The price of global IOUs is key to the health of the global financial markets.
The world is carrying too much debt – ultimately, that’s what’s been holding everyone back. It’s the Sword of Damocles hanging over all of our heads.
Debt has been at the heart of all of our economic and financial problems. The 2008 crisis was about debt – there was too much of it, and suddenly banks and individuals got scared that it wouldn’t be paid back.
The Greek crisis was about debt – driven into a deflationary hole by the euro, Greece’s debt burden just kept getting bigger and bigger and ever-less payable in real terms. Lots of people were holding said debt – or other debts reliant on it – and they suddenly didn’t know if they’d get their money back (or what currency they’d be repaid in).
Frustration with the general state of the world is about debt – central banks have been able to keep the sword suspended by printing lots of money and keeping interest rates suppressed. But they haven’t managed to do anything that might actually get rid of the debt.
Worse still, they’ve exacerbated the situation by making it ever harder for people to pay for the one debt-driven asset that almost everyone aspires to owning – a house. In Britain, certainly, if you want to buy a home now, you have to stretch yourself to extraordinary lengths.
Nothing dampens “animal spirits” like having a great big chunk of debt to pay off. You can argue that it’s the debt servicing costs that matter, but that ignores the psychological impact of carrying debt.
At the back of their minds, few people think that interest rates can stay as low as they are forever. So even if your mortgage is affordable today, there’s always the concern that it might not be quite as affordable in the future.
How to get rid of debt
How do you get rid of debt? As we’ve discussed before, there are really only three ways.
Pay it back the honest way – by growing your economy, boosting your output, and outrunning the debt that way.
Default on it the honest way – you just turn around and tell your creditors that you can’t pay, then try to come to an agreement.
Repay it the dishonest way – which is the same as defaulting on it the dishonest way: you pay off the debt by inflating it away.
Investors now clearly believe that Trump will manage to spark inflation with his policies. For now, they also seem to be betting on genuine growth too. Gold has fallen, which wouldn’t be the case if markets were expecting a stagflationary environment.
This is all bad news for bonds. Bonds pay a fixed income, so the price of the bond is set according to the desirability of that income (creditworthiness is an issue too, but if you’re talking about US Treasuries, credit risk – rightly or wrongly – doesn’t come into it).
Let’s say your local bank’s best interest rate on a savings account is 2% a year. If I offer to sell you a piece of paper that entitles the holder to a guaranteed £5 plus their money back at the end of the year, what would you pay for that? More or less than £100?
Unless you had reason to doubt my creditworthiness, then it’d be a good bit more, of course. Because a 5% yield on £100 is a lot better than 1%.
But let’s say the rate on the savings account goes to 6%. You now wouldn’t be willing to pay as much as £100 for my bond, because that 5% yield would look undesirable by comparison.
So that’s how bonds work. And in our recent deflationary and disinflationary era, bonds have become hyper-attractive. Many have traded with negative yields (whereby you pay to own the bond, effectively).
This could be good news for Japanese stocks
But now that’s reversing. And the further away from maturity (the payback date) the bond is, the wilder the swings. This morning, the 30-year US Treasury yield has gone above 3% for the first time since January this year. That’s quite a move, and it’s not the only one.
What does it all mean? We need to keep a close eye out. This could still be a post-Trump panic spasm. Maybe he won’t manage to get inflation going – after all, we’ve been trying for a long time.
But if this does mark the end of the global bond bull market, it would have serious ramifications for markets.
One of the most interesting opportunities right now though could lie in Japan. The Bank of Japan (BoJ) could be about to see its commitment to cap the ten-year Japanese government bond yield at around 0% tested too.
The BoJ promised that it would keep ten-year rates at 0% until inflation in Japan took off. No one took that promise all that seriously when it was announced near the start of this year, because the idea of Japanese government bond yields struggling back out of negative territory seemed so far away.
However, an open-ended commitment by a central bank to “print what it takes” when bond yields are rising has a very different ring to it from an apparently futile attempt to hold back deflation when yields are collapsing.
The yen has already weakened sharply against the US dollar after a brief post-election spike. If the global bond rout continues, it could fall a lot further, as the BoJ’s efforts to suppress yields make themselves felt in the currency markets. As we’ve already seen, that could be good news for Japanese stock markets.
We’ll be looking at all of this in more detail in the next issue of MoneyWeek magazine. If you’re not already a subscriber, you can sign up here.