A mountain of worry for investors

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It can often be a mistake to think financial markets are telling you useful things about real life. This is one of those times. As every reader will no doubt be aware, these are dark days in Israel. And the risk of a broader regional conflagration beyond Gaza is depressingly real. 

Markets, meanwhile, appear to be doing a very bad job of reflecting the gravity of the situation.

Investors’ muscle memory around outbursts of geopolitical tension is pretty strong. North Korean missile tests, the Arab Spring and the like typically trigger the same impact on markets as major natural disasters (in rich countries at least, I never said this was fair) — a flight to safety known, irritatingly, as “risk off”. This is irritating because people outside financial markets might quite reasonably think “risk off” means risk is falling. In fact, it means the degree of danger that investors are prepared to risk in a portfolio is declining.

In any case, the features of a flight to safety are consistent. In dark times, investors want safe stuff. Therefore, you see a push higher in government bond prices, particularly in US Treasuries. The dollar typically springs higher, as does the Swiss franc — another classic retreat. The Japanese yen, which is not quite the same kind of global currency, also does benefit when domestic investors pull overseas assets back home in times of trouble, or more accurately when traders around the world think they will. Gold prices normally rise.

Right now, this is not really happening. Gold prices have certainly climbed, albeit not to sky-high levels. Even after the 8 per cent rally since the Hamas attack on October 7, prices are still down by 3.5 per cent since May. Similarly, the oil rally that fizzled in late September is back on, a reflection of concern that other Middle East states could be sucked in to the conflict. Again, though, the ascent in prices is modest and still leaves us comfortably under $95 a barrel.

The real curiosity, though, is in Treasuries, which have been sinking in price at a spectacular pace, shoving up yields in the process. Anyone with a passing interest in markets will be aware that yields, a cousin of benchmark interest rates, have been heading higher for more than a year, but they are reaching eye-popping levels now and have stretched further over the past week. At close to 5 per cent, 10-year Treasury yields are at their highest point since 2007.

One potential interpretation here is that while the news from Israel is ghastly, the probability that other countries get directly involved is low. By that measure, this is an intensification of the violence we have become accustomed to over decades, but nothing more.

Another is that the fear is real, investors are taking this seriously, but right now they have their own mountain of worry to climb. Much hinges here on the specific mountain in question.

The Bank of England’s chief economist Huw Pill inserted this in to the markets’ consciousness back in the summer, when he said interest rates were likely to resemble Table Mountain — high but flat at that high level. This is a nice visual metaphor for the higher-for-longer formulation that investors are struggling to learn to live with.

As he pointed out, the alternative tactic follows the shape of the Matterhorn — an altogether pointier mountain. In this framework, rates push higher but central banks quickly pull them lower again. This route is proving popular in emerging markets and deep down, big investors have been hoping the US and other major economies will do it too, despite constant warnings from policymakers that they will not relent until inflation is properly under control.

True acceptance that central banks are really not going to cut rates quickly and rescue asset managers’ crumbling bond portfolios is proving elusive. Time and again, investors call the top in yields and say now is the time to pounce, buy the bonds, lock in the returns for years to come. That does make sense for those buying bonds such as Treasuries or UK government debt that has little to no chance of default with the intention of holding them to maturity. But time and again, those calling the top in yields are simply wrong. 

“Huw Pill talked about Table Mountain, but I think it’s more like Ben Nevis,” says Trevor Greetham, head of multi-asset at Royal London Asset Management. “You keep thinking you are at the top but then the mists clear and you are not.”

For as long as bonds remain stuck in this fog at the summit, it is hard for other haven trades to work either. The dollar is unlikely to back down against the yen, for example, while yields are somewhere close to the peak — the correlation between those two has stood the test of time.

Still, bondholders cling to hope. More than half of fund managers still expect yields to head lower in the next 12 months, according to Bank of America’s latest survey — the highest share on record going back two decades.

One day they will be right. In the mean time, not even serious geopolitical pain is enough to give them a break and cool the capitulation. Table Mountain may have a flat top but it casts a long shadow.

katie.martin@ft.com