Beware the ultra-long trap

The bond market world has moved into strange territory of late. Around one quarter of the debt issued by governments and companies is currently trading at negative yields and in Germany government bonds are yielding negative rates of interest out to a maturity of 30 years. In effect, investors are paying the government for the privilege of owning their debt, quite a long way out across the maturity spectrum. This does not mean that investors periodically hand over a sum of money to the government, but it does mean that the stream of income that the bond pays is less than the amount the investor paid for the bond.

Why would anyone be prepared to do that? The simple answer is that investors need the reliability and liquidity that high quality bonds can provide when they have to allocate their portfolio over a wide range of assets. Think of it this way: Even though investors would have maximised their returns over the past decade if they had been fully invested in equities, at no point could they ever be sure that the bandwagon would keep on rolling. Theory suggests that long-term returns are maximised if the portfolio is spread across a range of assets, and the likes of pension funds are required to allocate a minimum portion of their portfolio to bonds in order to meet their payout obligations. Even now pension fund providers will not hold less than 40% of their assets in bonds, and although the returns may be miserable the buyers of high quality government (and corporate) debt are highly likely to get their money back. The bond market is thus a safe place to store wealth – a hedge in an uncertain world.

On the basis that demand for bonds is unlikely to dry up, despite low interest rates, governments arguably have a strong incentive to issue debt at current low rates, either to finance additional spending or refinance existing debt. Moreover, they have an incentive to issue much longer maturity debt than previously in order to lock in these rates for as long as possible. One would think that no rational investor worth their salt would buy bonds issued with a negative coupon rate. Think again. In August, the German Federal Finance Agency sold a 30-year zero coupon bond (i.e. it pays no interest) but because the bond was sold at 3.61% above par (i.e. investors pay 103.61 but receive only 100 at maturity) this amounts to a negative interest rate of 0.11% per annum if the bond is held to maturity. Demand fell short of target, with sales of €824 million versus a target of €2 billion, but it was generally perceived as a useful trial of the extent to which the market was prepared to accept low rates.

In 2017, before yields fell to current levels, two countries – Austria and Argentina – decided to test the demand for ultra-long issuance by selling 100 year bonds. Their experience has been rather different, with the price of the long-term Argentinean bond since halving in value whereas the Austrian bond has doubled. It is understandable that Argentina tried to lengthen the maturity of its debt profile – it has been a serial debt defaulter over the last 70 years with five episodes of default or rescheduling since 1950, so it made sense to reduce disruptions caused by debt rollovers. But this history also weighs on investors. Can Argentina really be trusted not to default on its debt in the next 100 years? In order to get investors onboard, Argentina had to issue at a coupon rate of 7.9%. That might seem high in the context of the US or Europe, but with the central bank benchmark rate at 74.98% and 10-year yields currently trading at almost 28%, it does not sound quite so bad.

One country which could conceivably get away with issuing longer dated bonds at low coupons is the US where the Treasury, which only issues as far ahead as 30 years, is mulling the possibility of going even further out along the curve to maturities of 50 and even 100 years. Treasury Secretary Steven Mnuchin said last month that “we are looking at potentially extending the portfolio. If there is proper demand, we will issue 50-year bonds.” He went on to suggest that if these bonds prove to be a success, the US would consider the possibility of 100-year bonds. Historically, the US has issued debt at longer maturities and between 1955 and 1963, it sold bonds at maturities up to 40 years (here). In 1911, it even issued a 50 year note to fund the construction of the Panama Canal.

But as attractive as long-term issuance sounds, there are a number of factors to consider. History cautions that issuers have to strike a balance between offering yields which are sufficiently attractive to investors but which minimise the costs to the issuer, and as the US found in the 1950s and 1960s that is a difficult balance to get right. One of the reasons for sticking to the current maturity schedule is that the US Treasury has tried to avoid tactical or opportunistic offerings of debt, and has focused instead on maintaining a regular and predictable schedule. This has helped the US Treasury market to become amongst the most liquid financial markets in the world. This in turn allows the government to offer relatively low coupons in return for the privilege of liquidity and helps to keep down Federal debt servicing costs. Issuing ultra-long debt threatens to reduce market liquidity which might in the long-run push up US rates.

Odd as it may sound, almost 20 years ago there were fears that rapid US growth and declining budget deficits would lead to a shortage of Treasury securities. Obviously that never happened, but in a world where there is a move to increasing the duration of debt we could get to a situation where there are temporary issuance droughts which could distort the shape of the yield curve. If there is an increase in the proportion of debt issued at longer maturities, a prolonged period of reduced issuance – perhaps because of rapid growth and smaller fiscal deficits – could mean a shortage of supply at the short end of the curve which would push down yields (i.e. raise prices) and result in a significant steepening of the yield curve. The point may be hypothetical but it demonstrates that changing the duration of debt issuance could have significant market consequences.

It is a mark of desperation that investors would even consider buying such long-dated bonds, particularly at a time when global uncertainty appears so high. Although the US continues to issue the world’s reserve currency, in which case it makes sense to buy dollar bonds, we cannot say that will be the case in 100 years’ time. Nor can we be sure that even the US will be able to pay its debt. After all, those British and French creditors hoping that the Russians would finally pay up on their pre-1918 debt are still waiting. And if we cannot be sure that even the US will pay up, who can we trust?

Border disorder

It has been a tumultuous week in the world of British politics as the political establishment tears itself apart over the issue of Brexit. With just 29 days to go, Boris Johnson reiterated at today’s keynote speech to the Conservative Party conference that the UK is "coming out of the EU on October 31, come what may." There is only one way that this can be achieved and it requires the UK and EU to agree a deal that will enable the transitional arrangement to come into force which will prevent a no-deal Brexit. For all the ongoing excitable talk in the press, no doubt whipped up by Conservative sources, that the government is prepared to leave without a deal, do not forget that to do so would be a breach of the law. Parliament has already ruled out this option and having lost one legal battle, Johnson would not relish the prospect of MPs once again resorting to the courts to force him to comply.

If ever there was a time for ignoring press chatter and speculation, now is that time. Ahead of Johnson’s speech, there were stories suggesting that the government would unveil its strategy to deal with the Irish border problem, and present it to the EU as a “take it or leave it” option. That was not what we got. The rhetoric was far more conciliatory as the government presented a plan which allows for regulatory alignment between Northern Ireland and the Republic for a limited period of time. But it is what happens once the transition period ends that is far more problematic.

At that point, Northern Ireland will leave the EU customs union and revert to being part of the UK customs union. However, the North will be fully aligned with the EU for the purposes of the agri-food business and “in addition, Northern Ireland would also align with all relevant EU rules relating to the placing on the market of manufactured goods.” This effectively means the creation of two borders: A regulatory border between Britain and Northern Ireland for manufactured goods and agri-food products but a customs border between the North and the Republic.

Moreover, the British government has reiterated its position that “no customs controls necessary to ensure compliance with the UK and EU customs regimes will take place at or near the border.” Instead, they will rely on “continuing close cooperation between UK and Irish authorities” with movements across borders notified using a declaration process, utilising processes such as the trusted trader scheme which the EU has already rejected as unworkable. None of this sounds to me like a solution that the EU can buy into – it is all a bit vague. And from the EU’s perspective it gets worse. The UK has proposed that every four years, the Northern Irish electorate will get a chance to have its say on the regime to ensure that it is still satisfied with the arrangements. But “if consent is withheld, the arrangements will not enter into force or will lapse … after one year, and arrangements will default to existing rules.” This is clearly not the permanent solution to the border problem that the EU is seeking. In its current form, I would be highly surprised if the EU accepts it. Indeed, chief EU negotiator Michel Barnier was reportedly scathing of Johnson's Irish border plan, describing it as "a trap".

The best way to view the proposal is as a starting point for discussion. But it all seems a bit late although that seems to be the only way that anything gets done in these negotiations. Clearly the EU does not want to reject it outright since this would effectively scupper any chance of a deal at the summit in two weeks’ time. The question is then how much are the British prepared to bend to accommodate the EU’s requirements (and vice versa)? And where does it leave the Democratic Unionist Party? After all, they were the ones who objected to a customs border between Northern Ireland and the mainland yet that is exactly what they have now signed up to.

But Johnson is now entering the most critical phrase. His mantra “let’s get Brexit done”, for which read "leave the EU on 31 October", rings increasingly hollow. It is 100% certain that Brexit will not be “done” by the end of this month even if the UK leaves the EU. The October deadline represents a staging post which would at best mark the start of negotiations regarding the nature of the UK’s long-term relationship with the EU. As a third country with much less bargaining power than the EU, the UK will be in a much weaker position than it is now and negotiations will be a lot tougher than anything seen so far. As a consequence, the economic uncertainty that has held back business investment over the past three years is likely to persist – a point made by MPC member Michael Saunders in a speech last week.

Although the Conservative government believes that it will be possible to reunite the country once it has dragged Brexit over the line, I continue to have my doubts. A no-deal Brexit will exacerbate, rather than heal, divisions and the damage to the UK as a business location may already have been done – a view I heard expressed at a business forum I attended yesterday. Brexit long ago stopped being about the economics and simply became the toughest battlefront in what now has to be seen as a culture war. But the economics matters – ultimately it will determine whether Brexit is deemed a success. I am not holding my breath.

"Politics, bloody hell"

Following Manchester United’s dramatic Champions League final victory over Bayern Munich in 1999, Alex Ferguson’s surprise and delight was expressed in his post-match comment “football, bloody hell.” Substitute politics for football and that encapsulates events of the past 24 hours in British politics. The most dramatic event was the decision by the Supreme Court which found Boris Johnson guilty of unlawfully preventing parliament from fulfilling its constitutional function of holding the government to account. Under normal circumstances, that would be sufficient to render a PM unfit for office – indeed, most employees losing a court case in such circumstances would expect to be fired – but these are not normal times.

In 62 days as Prime Minister, Boris Johnson has lost six parliamentary votes; a by-election; his parliamentary majority; 23 MPs and a major court case in which he was found guilty of flouting the UK’s democratic conventions. These are the actions of a serial loser and were he a football manager Johnson would surely have been fired by now. But for all that, when Johnson finally does get the election he has long wanted – probably before year end – I fully expect him to win (or at least lead the largest party in parliament). And that is because he faces the least competent leader of an opposition party in the history of modern British politics.

Not what you are for but who you are against

For those of you not following the details, the Labour Party conference which is taking place this week shows a party which is in disarray and is remote from the concerns of the electorate. Jeremy Corbyn rejected efforts by party members to adopt a clear stance on Brexit before any general election by gerrymandering the process (par for the course in modern British politics). By packing the conference hall with supporters and calling for a show of hands, rather than allowing the trade unions to put their support behind moves for a second referendum, Corbyn has adopted a position which effectively amounts to “vote for us and we will tell you what our position is after the election.”

Those younger voters who flocked to Labour in 2017 in the belief that the party opposed Brexit will not vote for Corbyn again. The wider electorate is suspicious of a party which has what can only be described as a socialist agenda, and if it will not address the concerns of voters on Brexit, the moderates will desert in droves. I wrote in September 2015, soon after Corbyn was elected leader, that he would never be elected prime minister (“the general consensus at this stage is that Mr Corbyn is unelectable”). I believe this to be even more true today and this week’s conference decisions will go down as the moment Labour lost its chance to win an election.

Keep calm and carry on

Therefore, as bad a PM as Johnson is, all he has to do is hang in there and he will be returned to Downing Street at the next election. Indeed, although Johnson has been thwarted at every turn in his efforts to deliver Brexit, he is pulling out the stops to make it appear that he is prepared to do whatever it takes. This sort of stuff plays well with the half of the electorate that voted for Brexit and just wants to get on with it. It almost does not matter whether Johnson is successful in his efforts to prorogue parliament: By promising to deliver “do or die”, he has made himself into a martyr for the Brexit cause which will suit him as he tries to win back those Conservatives who have defected to the Brexit Party.

In my view, the government now does not have to take the risk of pushing ahead with a no-deal Brexit on 31 October as it can point to the various efforts by other parties (parliament and the courts) to prevent such an outcome. Johnson has already established his Brexit credentials. Indeed, the government would be breaking the law if it decided to push ahead with a no-deal Brexit.  Much of the excitable commentary suggesting that the government might ignore the court and try to prorogue parliament for a second time is probably wide of the mark (or at least it should be. The PM would be well advised not to listen to his advisers).

It is also not inconceivable that a deal can be struck that ensures the UK can enter into the transitional arrangement with the EU on 31 October, as Johnson undoubtedly desires. After all, there have recently been signs that the DUP are apparently softening their opposition to the prospect of an all-Ireland solution to the Irish backstop problem. In short, Northern Ireland would be much more closely aligned to the EU’s customs rules and would mean rather different treatment to the rest of the UK. If this hurdle can be overcome, then the problem of imposing a hard border between the Republic and Northern Ireland falls away. The EU would certainly be open to this option. After all, they originally suggested it in 2018 only for it to be rejected by the UK government which did not want to see different rules being applied in different parts of the UK.

Far from the finish line

If, however, this cannot be achieved then an extension to Article 50 seems inevitable. But this will open up a whole new can of worms. There is already a huge backlash underway against “unelected judges,” which totally ignores the fact that the courts actually opened the way for parliament – the representative body of the people – to take control of the issue. Whilst it is unsatisfactory that the judiciary has become involved in politics in the way that it has over the past three years, it is even more unsatisfactory that the executive has shown such contempt for the democratic process. We are sailing ever deeper into uncharted waters as the government tries to square the unresolvable circle of Brexit. As Brexiteers continue to look for the knockout blow that will resolve the problem “once and for all” they simply create more collateral damage and heighten the risk of an even bigger backlash.

We do not know where it will end. Nor do we know when it will end, for it is often forgotten that delivering Brexit on 31 October simply means entering into a harder set of negotiations with the EU as the two sides seek to determine the longer term nature of their relationship. There is no pot of gold at the end of this rainbow. And even the rainbow now looks more than a little tarnished.

The power of discounting

Across the industrialised world house prices appear extremely high. Much of the commentary in the UK, where house prices have become a national obsession over the years, continues to bemoan the elevated level of house prices, arguing that it is unfair on the younger generation of potential buyers who have been shut out of the market. But it is not just a UK problem: The Riksbank in Sweden has been worrying about excessively high house prices for what seems like much of the last decade; the Swiss National Bank has made references to high residential property prices and even in Germany we hear concerns at the extent of valuations.

We can value house prices in one of two main ways, depending on whether you are on owner-occupier or a renter. An owner-occupier is concerned about affordability relative to their income so the price-to-income multiple is an appropriate measure. In the UK, average house prices are worth around 5x the annual income of a first time buyer versus a multiple of 3.5x over the period 1983 to 2007. On the assumption that they are unable (or do not want) to borrow 100% of the purchase price, this implies that prospective home buyers either have to save for longer to build up a deposit, or they put down a lower deposit and borrow more (i.e. they are more highly leveraged). On the basis of the OECD's data, UK house prices relative to incomes are 28% above their long-term average. But valuations are more extreme elsewhere. The data suggest that prices relative to incomes in Sweden are 44% above their long-run average; in Australia this rises to 46% and 56% in Canada (chart 1).

Renters care about their short-term rental costs relative to income, and I have used the OECD’s data on house price-to-income ratios and price-to-rent ratios to construct indices on rental costs relative to incomes. For the most part, rents appear to have grown more slowly than incomes over the last decade. Across the OECD as a whole, they are around 12% down relative to their long-term average versus 4% below in the euro zone (chart 2). But the cost of buying houses relative to the stream of rental income has increased sharply. UK house prices relative to rentals are currently 44% above their long-term average, whilst the corresponding figures for Sweden and Canada are 72% and 97%.

One of the standard arguments used to explain the elevated level of house prices is that the great recession of a decade ago impacted severely on residential construction, chopping out at least a couple of years of construction that would otherwise have been expected to take place to cope with rising populations. In the UK, this has been compounded by the lack of public sector housing, which has collapsed in recent decades. As recently as the 1970s, more than 40% of all housing completions were in the public sector. In the period 2003 to 2010 it collapsed to 0.1%. But as a couple of neat blog posts on the BoE’s Bank Underground website make clear (here and here) a lack of supply is not the whole story.

Like any asset, housing is valued according to the stream of services it yields. If we think of a dividend discount model, in which the price is determined as the future value of housing services discounted by the interest rate, it stands to reason that as interest rates collapse to all-time lows, so the discounted future value of future services (i.e. prices) will rise sharply. Housing services are valued in terms of rental income: If you buy a house and rent it out, you can directly value the income. If you buy a house to live in, the standard statistical approach is to measure the rent that you would otherwise pay to live in that house if you were a renter (imputed rent). But whichever method we use, low interest rates have clearly boosted house prices. This simple fact explains why prices have shot up hugely whilst rental costs have not – it is the power of discounting that has distorted the price-to-rents ratio. The authors of the BoE blog posts use this insight to construct a model which concludes that the rise in UK house prices since 2000 cannot be attributed to physical shortages – it is all about the interest rate.

Since it appears that for the most part, the price-to-rents ratio is further out of line with its historical average than the price-to-income ratio across the OECD, it is not unreasonable to suppose that this has been repeated across the globe. Obviously the extent to which prices diverge in different countries will depend on a variety of local factors. However, as  one respondent to the blog post noted, quoting an economist at the Australian Banking Royal Commission, ”the price of housing is a function of the demand for and supply of credit not the demand for and supply of housing.”

As a result, no amount of housebuilding is going to reduce house prices: Only central bankers can do that. However it does raise a question mark as to what happens if and when interest rates do start to rise. Reducing the discounted value of rents is likely to result in a sharp fall in house prices, and to the extent that housing forms a substantial part of household net wealth, falling house prices could squeeze consumption hard. Indeed, the severity of the 2008 recession in the US is partly attributable to the impact of falling housing wealth. At some point, some of the air will have to be let out of the bubble, even if it is still a long way off in the future. The bottom line is that some central banks will have to think long and hard about the damage that raising rates could cause and even small changes could have bigger effects than we are used to. What goes up must come down, and what goes up a long way must also come down a long way.

Five years and two referendums later

I was reminded today of the fact that it is exactly five years since the Scottish electorate voted by a majority of 55% to 45% in favour of remaining in the United Kingdom. Those were what have now come to be seen as the good old days. The decision came just two years after the 2012 Olympics when it felt like the country was pulling together. Despite concerns about the direction of economic policy, the Scottish referendum outcome reflected a decision to bury differences as the country looked to the future with some optimism.

Looking back at what I wrote at the time, I noted: “This may not be the end of the story. For one thing, given the significant swell of support for the pro-independence campaign it cannot be absolutely ruled out that they will push for a second referendum. This will add further fuel to a nascent English nationalist movement led by UKIP, which will thus set the tone for the May 2015 General Election. Once the election is out of the way, the next big item on the political agenda will be the prospect of a UK referendum on EU membership. The main lesson from the Scottish campaign is that it will cause a lot of bitterness.” I could not have foreseen in 2014 just how right that would prove to be.

It is extraordinary to think that less than two years separated the Scottish independence and EU referendums, such was the change in political sentiment during this period. The long-awaited publication of David Cameron’s memoirs, which have been splashed all over the newspapers in recent days, suggests he is deeply saddened by how the EU debate played out and he is scathing about the behaviour of colleagues such as Michael Gove and Boris Johnson during the campaign. But just as Tony Blair could never admit that the UK’s involvement in the Iraq War was a mistake, so Cameron cannot accept that he made a mistake in calling the EU referendum. He believes that a public vote was “ultimately inevitable.” But he is wrong. In early 2016, only 10% of voters believed relations with the EU were a pressing issue for the UK. It was well documented at the time that Cameron was trying to spike the guns of UKIP and I have consistently expressed the view since early 2013 that his call for a referendum was a gamble with the national interest.

Arguably, Cameron’s success in securing the "right" result on the Scottish referendum emboldened his decision to hold an EU referendum. With the benefit of hindsight maybe if the Scots had voted for independence Cameron might not have been so gung-ho about the EU plebiscite, and although UKIP would have continued to be an irritant, the rest of the country may not have torn itself apart over the EU issue. As it is, we are now in a position where the UK is only 43 days away from crashing out of the EU without a deal.

The release last week of the summary Operation Yellowhammer documents make clear the scale of the economic risks facing the UK if it does crash out without a deal. The document notes that “When the UK ceases to be a member of the EU in October 2019 all rights and reciprocal arrangements with the EU end. No bilateral deals have been concluded with individual member states [and] public and business readiness for a no-deal will remain at a low level, and will decrease to lower levels, because the absence of a clear decision on the form of EU Exit (customs union, no deal etc) does not provide a concrete situation for third parties to prepare for.” These are the outcomes that government told us not too long ago were unthinkable and now we find they are government policy.

Just to highlight the specific nature of some of the Brexit-related risks, “the reliance of medicines and medical products' supply chains on the short straits crossing make them particularly vulnerable to severe extended delays. Any disruption to reduce, delay or stop supply of medicines for UK veterinary use would reduce our ability to prevent and control disease outbreaks, with potential detrimental impacts for animal health and welfare, the environment, and wider food safety/availability and zoonotic diseases which can directly impact human health. Certain types of fresh food supply will decrease.”

In other words, the UK government’s inability or unwillingness to accept the deal negotiated with the EU last November poses potential health risks to the country’s population. These are not the hysterical ramblings of desperate Remainers – this is what the government has been forced to admit might actually happen. To further highlight the collapse in effective governance, far from preparing to meet the challenge, the government has suspended parliament in case it asks too many inconvenient questions and is now fighting a challenge to its actions in the Supreme Court. Nor does the madness stop there. For all the obvious shortcomings of Boris Johnson as Prime Minister, opinion polls suggest the Conservatives are actually extending their lead over Labour. To counter this, the Liberal Democrats have now adopted a repeal of the Article 50 notification as their official policy which is (a) unlikely to happen; (b) not particularly wise and (c) not the threat to democracy that the foaming-at-the mouth brigade would have us believe because all you have to do is not vote Lib Dem.

We live in febrile times and the anger that the Brexit debate has stirred up is not going to dissipate once the UK is out of the EU (or not). To put this into some form of historical context I have combined the post-1998 Baker, Bloom and Davis policy uncertainty index for the UK with their index covering the period 1900 to 2008 (based on a smaller sample so there are some comparability issues). Nonetheless, it shows that policy uncertainty spiked to its highest ever level in the wake of the EU referendum and even now is at levels consistently exceeded only in 1919, 1939 and 1946 (chart above). The UK economy is not merely suffering an economic shock: It is being subject to repeated convulsions which will not easily be healed. I fear it will take a generation to heal current wounds. The apparent civility characterising the Scottish referendum in 2014 seems like a lifetime ago.