Monday, February 18th, 2013

How Low Can We Go?

It doesn’t matter which currency we choose – sterling, dollars or euro – all our multi-asset models recommend a very low weighting in government bonds. This ranges from 0-3%, which is pushing the edge of envelope, even for a tactical asset allocation model. The obvious question is does this make sense, to which the equally obvious answer is that it depends which currency we are talking about.

Even the Governor of the Bank of England admits that yields on 10 year gilts are lower than the rate of inflation which the MPC will tolerate over the medium term. The only reason for investing in UK government bonds is if you think that you are going to lose more money in equities in the short term. This is always possible, but inflation fears tend to cause sterling weakness; sterling weakness is often a good reason to buy UK or emerging market equities.

Our euro-denominated model uses German bunds as its reference risk-free rate, which means it cannot invest in the peripheral government bond markets. But it can invest in investment grade corporate bonds and emerging market bonds. For now, the threat of a eurozone break-up has receded, but sooner or later these fears will return. This would be a risk-off event by definition, but may not translate into a one-for-one increase in holdings of German bunds. The reason lies in the behaviour of the FX market. It’s not a proper crisis unless the external value of the euro declines. In this scenario our weighting of European equities would probably fall, but some of these flows would go into emerging market equities and bonds.

And so to the US: if the Congress cannot agree on a budget settlement, the sequester will come into force on or around March 1st. This must have an impact on GDP forecasts, and risk-appetite. US equities probably fall, but the dollar may strengthen which would reduce the attractiveness of emerging market equities and commodities. The impact on REITs and US corporate bonds is probably not that great unless there is newsflow which directly affects them – which leaves US government bonds as the main recipient of any flows out of risk assets.

Conclusions: If there is another risk-off episode in the immediate future, we expect UK investors to put less money into UK Gilts, than either Europeans into German bunds or US investors into Treasuries. Only in the US, would we expect the government bond market to be the main beneficiary of a general move away from risk.

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