Postcards from the Death Zone

A very long time ago my only need in life was flying. As a young man with no money, the only practical way to satisfy that need was in a glider (sailplane). You might easily guess at all the things that could go wrong in an unpowered aircraft that weighs about as much as your kitchen table, and is built of similar materials.

But one of the greatest risks for inexperienced pilots is a sudden onset of hypoxia, or oxygen deficiency. As young and novice pilots, we were therefore given very stern warnings about the deadly effects above 10,000 feet (3,048 meters) where supplemental oxygen was an absolute must. Stray above that height without it and the early symptoms are euphoria, confusion, target fixation, impaired vision and poor judgement. As you might imagine, for a pilot, these are very bad things indeed. My flying manual even saw a need to follow the clinical description of each effect with the stark warning; “=DEATH!”. (I suppose it was there for the unimaginative – maybe a trait common in young pilots).

My friends at the time who were mountain climbers were also well-versed in the dangers of hypoxia. In fact they had a prosaic name for the extreme heights where the body uses up oxygen more quickly than it can be replenished and humans cannot acclimatize: the Death Zone. I cannot remember us dwelling too much on the risks in those far-off and rather idyllic times, joyful holidays, picture-postcard sunny, with smiling boys and girls. But we were twenty years old. Which is to say, we were immortal.

Having survived youthful overconfidence at the controls of a Slingsby Skylark, I feel the irony now I am confronted by the symptoms of hypoxia from the safety of my desk: euphoria, confusion, target fixation. But we don’t call it hypoxia. We call it the bond market – or more truthfully, asset markets in general. (hopefully without the poor judgement in my case).

For markets, those feelings of euphoria stem not so much from a lack of oxygen, as a lack of yield. Specifically the low yields that followed years of aggressive central bank policy action and that are used to discount the prices of just about any asset class you care to mention to ever dizzier heights. And those feelings of confusion derive from a high degree of unease about exactly what comes next. Inflation is trending higher, and fast. Fixated on inflation targets, central banks struggle with their messaging and policy settings, and investors struggle to process what it all means.

This combination of euphoria and confusion might not mean “=DEATH!” exactly but, if not managed appropriately, could still lead to rather uncomfortable outcomes. Savings in fiat money are certainly not immortal. As we grapple with what it all means, the dangers for investors are evident in the market reaction to recent abrupt central bank policy actions. These picture postcards are not so dreamy.

Chart 1 shows the yield on 2-year Australian government bonds. Until recently the Reserve Bank of Australia (RBA) had deployed ‘yield curve control’ (YCC) as part of the policy toolkit. The basic idea was that, with policy rates already close to zero, intervening in markets to cap 2024 bond yields at 0.1% would stimulate lending via lower longer-term rates and be a powerful signal about the RBA’s intention to keep policy rates low. This seemed to be working well….until it didn’t. In the last few months inflation across developed markets stayed stubbornly high, challenging the ‘transitory’ thesis. A wave of selling by investors forced 3-year yields higher, to above 1.0%. In a shock move, almost overnight, the RBA stopped defending the 0.1% target; bad news for those holding short-dated Australian government bonds in expectation the RBA would hold the policy line.

Chart 2 shows a similar picture, but this time in Canada where the Bank of Canada abruptly halted its quantitative easing asset purchase program in October. The drivers for the unexpected policy shift were similar to those in Australia and came in the face of market pressure on higher yields.

And, just like Australia, the abrupt shift in policy stance led another burst higher in yields – although admittedly these have recovered somewhat on recent news about COVID mutations. Again, bond investors expecting ongoing central bank support were left nursing their losses.

Finally, Chart 3 shows 2-year rates in the UK where the Bank of England struggled with its policy communication in recent weeks, confused many, and left the yield path resembling a bad landing by a rookie pilot: bump, bump, bump, all the way down the airstrip. Onlookers holding their breath waiting to see how you finally settle¹.

These stories have three things in common: (1) earlier in the year, short-dated bond yields were trading at close to zero (or even below in the case of the UK), so investors were oxygen-starved of any yield at all to offset price losses if yields did move higher, (2) an evolving narrative about the inflation outlook that forced yields sharply higher and (3) markets were then taken off guard by abrupt central bank policy changes. The result is that many investors in short-dated, developed-market government bonds, typically regarded as among the safest investments, have seen year-to-date mark-to-market losses.

And the worst may not be over. Even after the recent correction, the yield on the ICE Bank of America World Government Bond Index (a typical index followed by many investors) is still only about 0.6%. See Chart 4. Nobody can say for sure exactly how the inflation story will unfold – there are some arguments still for inflation to fall back in 2022 (but even the Fed has torn up the ‘transitory’ flight-plan). And yet there are structural factors in play that could completely derail that idea and keep inflation running hot². The crucial point is that with yields at these levels the cushion for investors is still very skinny indeed – especially in short-dated bonds at the front of the yield curve. If inflation (or indeed inflation expectations) pushes higher from here losses will get worse for the unprepared.

In fact it is worse than that. When talking about yields so far, we were talking in nominal terms (i.e., before inflation). With yields at such low levels the likelihood of a negative real return after inflation is rather high. Take, for example, the US. The current nominal yield on the ICE Bank of America 3-5 year US Treasury Index is about 1% today. In Chart 5 we have subtracted the 3-year rolling average US consumer price inflation (CPI) from the nominal index yield to show the index real yield, as a residual, after one measure of inflation. Clearly the income from Treasuries has progressively failed to offset the effects of inflation over time.

Remember too that most central banks in developed markets work to inflation targets of around 2%³. Even if yields did not rise further from here, and today’s high inflation prints do prove transitory, in many countries sovereign nominal yields are still below the central bank inflation target. Economists have a name for our disposition to focus on nominal returns and forget about the damaging effects of inflation: the money illusion.

What can be done? Well, the first step is simply to know what is going on around you – or ‘situational awareness’, as your flying instructor might have told you a hundred times. With hypoxia, the symptoms are hardly noticeable at first; mild confusion about what is happening, some indecisiveness, denial, a poor decision and then very quickly things are spiralling out of control – literally. So it is important to be vigilant and take corrective action when necessary. Today that will mean accepting that the world is changing. For many years short-dated government bonds have provided a safe haven with decent returns as inflation, and yields, trended down. Now we have arrived at a point where yields are still close to zero but the upside risks to inflation are much higher.

An environment-aware approach to the fixed income allocation will adjust to this reality. This will mean moving away from a static, high allocations to bonds which have a high probability of generating a negative real return after inflation, and into a more flexible approach. But one that can also adapt quickly. While upside risks for inflation are certainly higher, that is not to say they will manifest. Nobody can say for sure how the post-COVID world will evolve⁴. Technological innovation, baby boomers entering retirement and very high government debt from spending to combat the pandemic could easily combine to decrease interest rates. Our flexible solutions aim to balance these risks by taking an active and diversified approach to managing fixed income exposure. You can find out more about our fixed income offering here.

³ Note the actual Fed inflation target is core personal consumption expenditure which, while lower than CPI, is still tracking well above 1%
⁴ Or how long this will take – as I write, the world scrambles to digest the impact of the Omicron mutation.