Economics and Strategy
―David Zervos, Global Head of Fixed Income Strategy & Economics
Back in the early ‘70s, as the oil price shock began to hit hard, speed limits in the US were cut to 55mph. The government, in an attempt to limit fuel consumption, came up with fancy slogans like "Fifty is Thrifty" and "Speed Kills" in order to justify the lower limits. But interestingly, to this day, trying to correlate higher speed limits with increased road fatalities has been a dubious exercise. And as a consequence, many states have been consistently raising speed limits over time.
The lesson on speed limits from the ’70s is an important one for our financial markets today. In general, there has always been a perception that risk is dangerous. After a crash, like that of 2008 and 2009, people panic and cut risk aggressively. Furthermore, consultants advise lower speed limits for pension funds and insurance companies. Regulators impose all sorts of new banking speed limits. Of course too much market speed can create problems. Excess leverage and excess exposure to risky assets have generated some epic crashes. But it has never been clear that government (or consultant) imposed "speed limits" reduce the size or number of crashes. In fact, one might even argue that the "rules" themselves have been the source of the crashes. Can anyone say "moral hazard"?!
In any case, the investing public has been sold on the idea that highly rated bonds are a safe hideaway from all the exuberance associated with driving fast in the risk asset world. But in a world where central banks set out to drive risk-free real rates highly negative, these traditional safe assets become different animals. They become highly risky products themselves. And to be sure, during this wondrous monetary experiment called QE, central banks have engaged in a process of "richening" these so-called risk-free assets. The idea is to incentivize investors to move into the overly depressed risk asset space. But a funny thing happened on this portfolio balance path to richening: Bond investors were lulled into a false sense of security. Folks thought that the richening of fixed income assets was actually a long term goal of the central banks. And now, after years of modest bond fund gains (which consistently underperformed risk assets), safety seeking bond holders are figuring out the sad truth. The asset they hold has been driven to 2007 Miami condo price levels - and the chief flipper in charge (Ben) is about to turn off the music and leave them without a bid.
If we look at a few charts on the move into bonds since the beginning of the crisis, it is downright frightening
(see attached). This little blip of an outflow in the last month or so is hardly noticeable. And while it’s always sad to see such an egregious misallocation of resources, we cannot say that investors were not warned. Certainly we have been opining on the dangers of risk free assets for years! And we have not been alone.
As reality sets in, and we begin to see consistent bond fund outflows, fixed income markets will enter into a state of disarray (take a look at the screens today as a guide post). For many investors there will be some hard lessons learned in 2013, but nothing will ring more true than the simple slogan, "Safety Kills"… It is quite interesting that those folks who ran away from developed market risk assets and piled into the ostensible safety of bonds, gold or even developing markets have been torched this year!
We need a new bumper sticker for 2013: "Safety Kills". That will go on the back of my car as I drive down to spoo and nikkei risk asset highways with Sammy Hagar blaring. Of course the song will be "I can't drive.....55". Good luck trading.