A deep plunge in the midst of the summer heat

As recession fears rose last week, government bond yields in Europe reached new lows. In our opinion, a long-term investor ought to seek better investments than assets that will yield negative nominal returns over several decades.

Last week, European bond rates reached historical lows, plunging deep into negative territory. In the most extreme case, the 10-year yield on Swiss government bonds crossed the −1% landmark, well below the current and already very negative short-term rate. Even more striking, the yield on Switzerland’s longest duration bond, maturing in June 2064, also dived below 0, crossing the −0.30% line. Meanwhile, the yield on the German Bund reached −0.60%, and the French OAT 10-year yield, which earlier in the year had for the first time turned negative, reached −0.35%. As improbable as it might seem in the current political context, even Italian BTPs were yielding negative returns up to two years out. The best performing government bond of all, Austria’s 100-year bond, is up more than 60% this year and, at some point, was yielding less than 0.75%, around 1% below the European Central Bank’s inflation target, and even below current inflation levels. Needless to say that all these bonds are expected to provide their long-term buyers with very negative real returns.

Surely there must be better investment opportunities for a long-term investor than a negatively yielding bond with a maturity of more than a decade

How can it make sense to seek negative yielding bonds over such a long time-horizon? To be clear, this question is unrelated to the ill-placed indignation we sometimes read about regarding the “unfair tax” on savers; no-one ever said that there was a fundamental right to get a guaranteed return on your savings. But surely, there must be better investment opportunities for a long-term investor than a negatively-yielding bond with a maturity of more than a decade. A well-diversified portfolio of equities – even an expensive one – is almost certain to do better over a 10- to 15-year period, for example.

According to Kenneth R. French’s data library, which goes back to 1926, the longest drawdown in US equities lasted just over 15 years. It started with the 1929 crash, after equities reached a very high valuation peak, and ended in 1944 as the Axis started to crumble. The second-longest drawdown was triggered by the burst of the dotcom bubble and lasted less than seven years. Now, even if we imagine that we are about to head into a crisis on the scale of the Great Depression with its subsequent geopolitical consequences, how likely is it that all these government bonds will pay out as expected? There is a very well-documented history of defaults on domestic debt, typically in times of crisis, that are both implicit through inflation, and explicit through proper debt restructuring.

Sooner or later a solution will emerge, boosting growth and inflation, and hammering European government bonds

Obviously, the current European establishment increasingly fits the definition of insanity (wrongly) attributed to Einstein: doing the same thing over and over again and expecting a different result. The fact that Europe seems to be stuck in a dead-end is legitimately a source of worry, if not annoyance. However, sooner or later – and we are not talking decades here – a solution to this mainly political problem will emerge, boosting growth and inflation, and hammering European government bonds. This will, in most likelihood, take the form of large-scale public investments financed through debt, typically to carry out the transition towards a sustainable de-carbonised economy, the perfect project to reconcile both sides of the political spectrum.

Alternatively – and let’s dream a bit here – there is the possibility that central bankers, or legislators, will support a much needed, pragmatic reform of our monetary system, allowing for the outright distribution of debt-free money to households and/or public entities, a measure often referred to as “helicopter money”. In both cases, higher growth and a moderate level of inflation is to be expected. Of course, there is also the (remote) possibility that the current standstill lasts long enough for populists to truly take over most European countries. However, it is unlikely that holding the promise of a stream of tiny nominal cashflows from treasury departments is the best hedge against that particular scenario.

There are clear signs that at short timescales, financial markets are not behaving like they used to

Leaving aside institutional constraints, which explain, albeit only very partially, the unabated appetite for fixed income, any sound long-term investor ought to seek better investments, both in terms of expected return and associated risk. The good news is that they exist; we definitely find some here at QUAERO CAPITAL.

So why are investors buying these ludicrously expensive bonds? One simple explanation might be that capital markets are increasingly driven by trading-oriented participants applying a “greater fool theory”: buying a financial asset purely on the belief that someone else will (or at least might) soon be willing to pay a higher price for it. Irrational bubbles are not a new phenomenon, but they seem to have reached an unprecedented level in recent years. When looking at the performance of bitcoin and, more importantly, the attention and support this valueless token sometimes receives from financial professionals and journalists alike, one can wonder how many people still remain in the sector to carry out the ultimate role of capital markets: to allocate efficiently savings towards investments in the real economy. Less anecdotally, there are clear signs that at short timescales, periods of weeks to months, financial markets are not behaving like they used to, indicating an overwhelming level of fast-trading behaviour amongst market participants. But that will probably be a subject for another letter…

In the meantime, we hope you will find a way to keep your cool this summer that doesn’t require deep diving into uncharted depths.

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