Bonds - from risk free return proxy, to a yield free return!

All valuations are relative. Relative in terms of anticipated returns and relative to the perceived forecasting risk that these will not materialise. Within an asset class, these can be benchmarked against that class in order to compare the individual components, but what about across asset classes? Here the concept of the 'risk free' return has been used as the anchor, albeit what might be an appropriate proxy for this will have changed through history. Ahead of the development of a liquid market in government backed debt, this may have been land rents, as we suggested back in our February 2019 posting, (chart also reproduced below). Since the emergence of the inflation adjusted bond markets (US TIPS and UK Indexed Linked) in the 1980's however, this has gravitated firmly into this orbit, and in particular, around the highly liquid long term US Treasury (TIPS) markets. 

An unintended consequence of Government/Central Bank attempts to manipulate asset values by artificially depressing Government bond yields however,  has been to undermine market confidence in using these instruments as a proxy for the risk-free return, as we have highlighted in our Market ECC section. That is not to say that government bond yields, and particularly US Treasury yields no longer remain a crucial bellwether for equity markets, but that this has more to do with the signal these provide as to government's monetary policies and continued preparedness to pump liquidity into markets. As in Octavius's day, more supply, in this case of money/credit, the cheaper the price (interest rates) and consequential increase in alternative assets.  

As the Bank of England noted in 2013,  "QE1 had clear effects on financial markets: gilt yields fell by around 100 bps and other asset prices rallied".

10 year comparative yields

The Euro area is a fiscal basket case that lacks a guaranteed tax base for its fiat currency, yet has been able to manipulate down its average 10 year Govt bonds yield to -200bps ldiscount against comparable US Treasuries. 

QE, meanwhile, has left the ECB 'balance sheet' at over 40% of Euro area GDP and over double that of the US Federal Reserve, provides the explanation, as well as for the increased push for political union so as to secure the 'transfer union' needed to underpin the leverage before the proverbial wheels fall off.

Inflation expectations

Lower yields from QE have fortunately not overly distorted the gap between fixed and indexed linked (TIPS), which still provides an important metric for inflation expectations being priced in by markets. Few surprises here that these have broadly mirrored the ongoing rates of CPI.

Yield curve

The flattening of the yield curve is often cited as the prelude to recession, albeit this can sometimes persist for years without such an event. More relevant is when the short-end of the curve breaks lower following such a period as this is often an indication of central bank panic liquidity injections as it sees evidence of said recession. 

The Fed flip-flop from November 2018 and the recommencing of its 'non-QE QE' from Q3 2019 provides a somewhat worrying case of 'deja-vu' on this subject!

European land rents real ROIC 1200-1800

Land rents

A 4-5% pa real ROIC on Land from 1500-1800, yet we are supposed to believe a sub 1% real Treasury bond yield is the new normal after just a few years of massive central bank manipulation.  

While evidence of interest rates on loans extends back to the usurious Mesopotamians at 20% pa, most rate in antiquity seem to have ranged from the Greeks 10% (dekate), the Romans 8 1/3rd (ubcia) and down to Justinian’s 5%, so perhaps not so alien to the more recent experiences, pre QE that is!

Better records since the Middle Ages on both Land returns and rents, together with inflation and land values however, provide a more reliable metric for returns, both absolute and real.  Using research from  Gregory Clark (UC-Davis), one can see a relatively high gross yield was available on property in the middle Ages of around 10% pa actual and between 8-10% real, but the dropping to a relatively stable 5% pa from 1500’s to the 19th century, with real yields of just over 4% pa.  

Source: The Interest Rate in the Very Long Run: Institutions, Preferences and Modern Growth   Gregory Clark (UC-Davis) April 2005