Long-dated US bonds offer investors hope
It’s been a bad year for bonds and shares. We have seen markets dominated by the actions of the leading central banks as they have struggled to adjust to the new reality of high and rising inflation.
I kept the bond part of the portfolio in short-dated index-linked bonds and in cash and near cash for much of the year, waiting for the US Federal Reserve and the other leading central banks to get on with increasing interest rates and forcing bond prices down.
More recently I have put money into longer-dated US Treasuries as the yields offer better value.
Earlier, I took the share portfolio out of stocks on the tech-orientated Nasdaq and cut exposure to the growth sectors that were subsequently hit hard in the sell-off.
The share part of the portfolio has lost a bit less by holding a better diversified world share exposure. But it was still affected by the big change of mood and outlook and the widespread global share market falls. The FT portfolio as a whole was down 11.4 per cent for the year, on December 1.
The year 2022 has reminded investors how dependent asset values are on supportive central banks. The great bull runs of recent years were fuelled by huge bond purchase programmes by the central banks, which paid ever- crazier prices to depress interest rates to around zero.
I never saw the advantage of buying bonds that offered no income in the hope someone would buy them from you for an even higher price. The central banks bought many bonds well above their repayment value. This means these banks are now sitting on large unrealised losses which will crystallise when they sell their bonds in the market in so-called quantitative tightening programmes, or when the bonds are repaid on maturity.
The central banks are also losing money by holding the bonds, as the income they receive on them is now less than the interest they have to pay out on the reserves deposited with them by the commercial banks. These reserves are inflated by the cost of the bonds the central banks bought being now reflected in commercial bank deposits.
The Fed and the European Central Bank were slow to stop the bond buying and they have been slow to get interest rates up to the levels needed to bring inflation down to the 2 per cent target.
This has strung out the misery in the markets and led to volatility around speculation on just how high rates will have to go and for how long. The recent Santa rally has come from many investors hoping that the Fed is nearing peak rates and will have to start to reduce borrowing costs as early as sometime next year in response to economic slowdown or recession.
It is true that money supply has lurched from far too expansionary to not growing at all. At the same time the US regulators are looking at requiring commercial banks to hold more capital, to make it more difficult for people and businesses to borrow. It should not take much more Fed action to bring price rises down. They need to avoid overdoing the severity of their policy. A slowdown followed by a pause in rate rises will be needed in the new year.
The refusal of the advanced country central banks to take money and credit growth seriously has added to the magnitude of the errors they made over inflation.
While, as the banks say, Russian president Vladimir Putin’s invasion of Ukraine led to a big spike in energy prices, inflation was well above target before the war began.
In China and Japan inflation has stayed much lower than in the US and Europe despite those countries being large energy importers. It is true the velocity of circulation or frequency of use of money can vary and might offset changes in the quantity, but it does appear that the places that boosted money and credit most now have higher inflation. We are all paying a high price for the inflationary errors.
Establishment wisdom tells us that central banks cannot go bust. That is just as well, as many of them have unrealised losses on their bonds many times their capital base. It is likely various central banks will be reporting negative capital as the bonds repay or are sold at a loss.
The theory goes that they can always create money to pay their bills, unlike any other company which needs to replenish share capital and reserves or cease trading.
Different accounting treatments will be used. The Bank of England has no problem because it will receive cash for all the losses made from the Treasury, which constantly tops up its capital.
The Fed has said it will report the losses and create a deferred asset on its balance sheet to offset them. This is said to represent future profits it expects to make sometime. The European Central Bank will require the national central banks in the Euro system to absorb most of the losses. If necessary these banks will have to be recapitalised by their governments.
Eurozone officials say there is now a transmission protection instrument available. This would allow the ECB to return to buying bonds in countries facing bond price falls and high interest rates compared to other member states. They claim they would not use this to help finance any government refusing to accept the disciplines of the EU and eurozone over deficits and general economic policy.
These pressures are likely to make the ECB more wary of raising rates too much and more reluctant than the US to go selling lots of bonds at a loss.
European rates remain unrealistically low for the inflationary circumstances. Policy will be more guided by keeping the euro states on side, by trying to avoid big divergences in rates between different countries, and by a reluctance to worsen the downturn.
In contrast, the US remains wedded to hawkish words and deeds to get inflation down quickly. Next year it is very likely political priorities will evolve in the US to show more concern about incomes, jobs and activity, which will lead to a mellowing at the Fed.
As the old year draws to an end, weary investors are looking for better prospects next year. Bonds in the US now offer better value. I will add more to the portfolio as we approach the slowdown and the coming pause in US rate rises.
Shares are well down and pointing to the downturn in growth and profits to come. January will see more debate about when governments shift from mainly fighting inflation, to combating a downturn that threatens to be too long and too deep.
It will be time to consider the share portfolio when we have a bit more data on the extent and nature of the downturn. We should still expect downward revisions to forecasts of profits as more sectors experience the kind of problems we can clearly see in falling US housing starts and in home sales numbers.
Sir John Redwood is chief global strategist for Charles Stanley. The FT Fund is a dummy portfolio intended to demonstrate how investors can use a wide range of ETFs to gain exposure to global stock markets while keeping down the costs of investing. john.redwood@ft.com
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