The Covid-19 crisis has pushed government bond prices to all-time highs, suggesting these assets’ reputation for safety remains as strong as ever. But there are good reasons to think the opposite: that US Treasuries have lost their some of their diversification advantages, and that central bank measures to encourage inflation will be ultimately ruinous for holders.
In the last financial crisis, America’s economy was at the heart of the storm. Yet global capital flooded into US Treasuries, thereby rewarding the chief source of financial instability. A similar pattern has emerged during the pandemic. Despite the US having the highest death and infection rates in the world, Treasuries have continued to play their traditional role as a haven for nervous international capital.
Looked at through the lens of history, “safe” has been an odd word to describe government IOUs. Middle-class people who lived through the second world war invested heavily in government bonds to provide for old age, as they had been heavily influenced by the deflationary conditions of the 1930s. The inflation of the 1960s and 1970s eradicated much of their wealth and impoverished their retirement.
That said, governmental paper promises are, in the absence of hyperinflation, a secure and serviceable asset in the short term. They are rightly the bedrock collateral for large parts of the financial system. In the longer term they are safe as a match for obligations such as future pension payments. But that raises a question: safe for whom? Safe, yes, for the sponsoring company of a defined benefit pension scheme looking to match its liabilities with fixed-interest assets. But for scheme members there is no safety once price rises exceed the inflation cap on their benefits.
This issue is particularly pertinent in the light of the super-loose monetary policy framework announced last week by Jay Powell, chair of the Federal Reserve. Henceforth inflation will be allowed to run above the Fed’s longstanding target to compensate for periods of undershooting. The notion of pre-emptive tightening has also been expunged from the central bank’s modus operandi. That definitively confirms the disappearance of any remaining anti-inflationary bias in US monetary policy.
Thanks to the devastating impact of Covid-19 on the economy, it will take time for inflation to pick up and for interest rates to rise. But in the end they always do rise, and that will inflict serious damage on supposedly safe fixed interest portfolios.
At the same time it is striking that government bonds this year have no longer been reliably providing relief when stocks fall. Since the start of the pandemic there have been times when the prices of equities and bonds have gone down together. So the notion of carrying a portion of safe fixed interest assets to balance riskier equity holdings is now suspect.
This continues a broader theme: as central banks have pumped liquidity into markets through vast bond-purchase programmes since the financial crisis, different asset classes have tended to move more uniformly. Fundamentals no longer matter for the overall market indices.
Longview Economics points out that there is a clear correlation between the S&P 500’s forward price/earnings ratio — a common measure of equity valuation — and the amount of so-called quantitative easing the Fed undertakes. In the past five months, the Fed has done close to two-thirds of the amount of QE it executed from 2009 to 2014. In this light, the dramatic re-rating of the equity market since March and its decoupling from the real economy makes more sense.
If government bonds can no longer be regarded as haven assets, what can take their place? The tech stocks that have driven the market rally this year — Apple, Microsoft, Amazon, Alphabet and Facebook — offer more safety than most. Unlike during the dot.com bubble, Big Tech is now highly cash generative. Nobel laureate Michael Spence has argued that these companies tend to have high levels of intangible assets and cost structures abnormally tilted towards fixed costs and low marginal expenses. This can make their platforms hugely scalable, which in turn confers significant pricing power.
He adds that stocks in companies in the S&P 500 index with high levels of intangibles per employee have recorded the biggest gains this year. The lower this ratio, the worse companies’ stocks have performed.
It seems counter-intuitive to think of equities as safe. But equally, it is hard to believe that government bonds yielding little or nothing are not a hostage to fortune when central banks are working overtime to generate higher inflation. For long-term investors this boils down to choosing between governmental paper promises and real assets such as property, commodities and gold. It is, in the time-honoured phrase, a no-brainer.
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