Prices (of bonds or, for that matter, of any assets) should be the discounted expectation of future cashflows. The S&P 500 is now within spitting distance of its start-of-year level, and 10-year Treasury
bond yields hover around 90 basis points per annum. Treasury bond markets are increasingly
seen worldwide as central-bank-manoeuvred equity puts. So, even if the focus of these notes is
on Treasury markets, more than ever one has to consider equities and fixed income together.
Starting from the equity picture, it would be hard to argue that undiscounted expectations of future cashflows should now be higher than at the start of the year. If prices are roughly the same, asset theory tells us that the risk premium must have compressed. A compressed risk premium should be an indicator of reduced risk aversion – a behavioural feature that is difficult to reconcile with the Covid-19 world we are living in. Asset pricing is at a loss in making sense of this.
Next, when equity prices swooned in March, Treasury prices duly rose – even if not quite as in sync with the S&P 500 or as much as the equity put-holders might have wished. Equities have now recovered, but yields have remained near their lowest values. The most disturbing feature is that since the 2008 crisis Treasury yields seem to display a ratchet-like behaviour: they drop at every crisis, but do not climb back up when the clear and present danger is over.
Now, in a healthy economy, Treasury coupons should be financed by tax receipts. These do not look very robust in the near-to-medium term future. On top of this, the US government is about to embark on a very large Treasury issuance: before the Covid-19 crisis, the Congressional Budget Office projected a $1.1 trillion fiscal deficit for 2020, or 4.9% of GDP. Moody’s now expects the deficit to be between 10-12%. Asset pricing theory says that these should not be good times for Treasuries either, yet prices are close to an all-time high.
If traditional asset pricing is of little help in making sense of these price levels, to what should we turn? Current prices (in all asset classes) can only be understood through the lens of the unconventional actions undertaken by the central banks. In their attempts not to add a financial crisis to a Covid-19-induced real-economy crisis, central banks all over the world have engaged in yet another extremely aggressive round of asset purchases. This is understandable, but the fact remains that the information about risk and reward that financial prices should convey has now become fully distorted.
Running out of ammunition
Quantitative easing started because traditional monetary actions at the short end of the yield curve began to hit against the zero bound. As long-dated Treasury bond yields in US dollars, euros and sterling are now close to or below zero, and controlled asset bubbles are developing in more and more assets, central banks are running out of ammunitions. If they want to continue their accommodative actions, they will have to keep on extending the asset classes in which they intervene. The price distortions are going tobecome bigger and more widespread. Prices will reflect less and expected discounted cashflows.
For how long can this continue? Ultimately, coupons and dividends distribute to capital providers what the economy produces after taxes and labour costs are met. We entered the Covid-19 crisis with stretched equity valuations, and extremely low yields. Thanks to the actions of central banks, equity prices are back where they started from, and Treasury prices are higher.
The balance sheets of central banks are therefore full of asset bought at prices that are unlikely to
reflect future cashflows. Would future central bank losses matter?
In theory, a central bank can always meet its (domestic) liabilities by printing money. This can only happen, however, if the central banks' liabilities remain a liquid and trusted method of settlement.
Recent academic studies (see Stella, 2010 and Dalton and Dziobek, 2005) show a link between central bank losses and inflation outcomes. And a rising inflation would, of course, make the now-easily-serviceable national debt no longer so easy to service. Which, finally, brings us back to the long-term risks for nominal Treasury bonds worldwide.
There is no telling how long this confidence trick can last – perhaps forever. But, as the 2008 ‘subprime’ crisis and the 2011 European sovereign debt crisis have shown, confidence can turn on a
dime: let us not forget the Greece 10-year yields were trading around 50 basis points above bunds as late as the start of 2007.
Riccardo Rebonato is Professor of Finance at the EDHEC-Risk Institute
This article first appeared in the Q3 2020 edition of Beyond Beta, the world’s only smart beta publication. To receive a full copy, click here.