The Pretender

Last week we went to see the Foo Fighters at the Forum. Well, sort of. It was the Forum in Tunbridge Wells rather than LA, and it was actually the Faux Fighters, a cover band.

The Forum is great little venue and there was a good energy in the room, despite the lead singer confusing Tonbridge with Tunbridge Wells at one point. It was a tense moment. You could sense a strongly worded email to the band manager was imminent!

When the band launched into ‘The Pretender’, it got me thinking (bear with me, I promise I am going somewhere with this) our job as investors is to identify who the ‘pretender’ in the market is, or more specifically, which asset is not behaving as it has in the past.

Currently, that asset is US treasury bonds.

US government bonds are historically seen as safe haven assets when investors are worried, and have been the bedrock on which portfolios have been built for decades. Yet, US treasuries are on course for a negative return for the third year in a row, and have delivered no positive absolute returns to any investor who bought bonds after 2015.

So why is this $25 trillion market melting down, and is this now a buying opportunity?

The beginning of this story was the return of inflation. Bonds that have a fixed interest payment in an environment of raising rates are not attractive for investors to hold and therefore sold off accordingly. Over the summer inflation softened in US but with a tight labour market and oil prices moving upwards inflation will remain stickier, and bond prices have continued to fall.

One of the main issues is rising US government outlays. Spending on pension and health care was already increasing but now the interest costs for government borrowing is going through the roof, and is becoming one of the biggest components of government outgoings. Such large and sustained deficits mean that debt will accumulate rapidly as the government borrows more to pay the higher interest payments. Additionally, when rates were low the US treasury didn’t lock in longer term debt and now have about a third of their bonds maturing in the next 12 months.

With more debt needing to be issued over the coming years then we need to ask who is going to buy these bonds? Not China anymore, their appetite for holding Treasuries has waned significantly. Not the Federal Reserve who are still in the process of shrinking their balance sheet. Insurance companies and banks are required to hold a certain amount of treasuries, and hedge funds have played an important role in the bond market in recent years. However, there are concerns about hedge funds, which use a lot of leverage, unwinding their bets at the same time and the domino effect of selling could dramatically cause liquidity to dry up. There is probably a reason why US Treasuries are currently being advertised to retail customers on podcasts!

Should the US fall into a deep recession and the central banks are forced to cut interest rates then we would see the value of US treasuries bounce back, however in an inflationary environment the bank’s ability to cut rates aggressively is somewhat curtailed.

The investment landscape has changed and investors must now seek alternative safe havens. At Five Horizons we are looking for contenders, not pretenders.


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