As US equity markets flirt with new highs, ultra-low bond rates – typically a sign of weaker economic growth – are confounding investors and unleashing a wave of corporate activity.
The disconnect between bond and stock markets is spurring an acquisition rampage among companies who are making the most of cheap debt and large cash piles. Typically investors flock to bond markets for safety when equity markets fall.
“The market is dangerous. Central banks are complacent. We in our lives have only experienced inflation but in 1890 prices halved. It was the norm in the industrial revolution,” David Tepper, who runs $US20 billion distressed debt hedge fund Appaloosa Management, said.
“There are times to make money and times not to lose money. This is probably a time to think about preserving money … I am not saying go short. I’m just saying don’t go fricken long,” he told the SALT hedge fund conference in Las Vegas.
On Wednesday, the 10-year US Treasury rate fell to a 6.5 month low of 2.5 per cent as dovish comments from the Bank of England and rumours that the European Central Bank was preparing to push short term rates negative led investors to believe that bond rates would stay low well into the future.
Meanwhile the yield on 10-year Australian government bonds has fallen to a nine-month low of 3.8 per cent and are down around 10 per cent for the year to date.
“Interest rates are going to stay low more than people expect and more than the forward curve is predicting,” said Jamie Dinan, founder of $US23 billion New York based hedge fund York Capital Management.
Mr Dinan said that low rates reflected the difficulties policymakers in the United States and Europe are experiencing in stoking growth and inflation, despite measures such as near-zero interest rates and quantitative easing.
“The two biggest economies in the world – the US and Europe – can’t create inflation. It’s been under 1 per cent for more than six months in Europe and in the US we have had a spigot for the last couple of years and we can’t get rates to 2 per cent,” he said.
“Now we are taking out the stimulus, our taxes are going up and our demographics are ageing. All these things are deflationary. There are inflation is certain goods but its not broad based, its just those on the top of the economic scale spending on things they want to own,” he said.
The risk for Australia, the US and much of Europe is that as the baby boomer generation ages, and birth rates stay anchored, that it opens up a skills and labour shortage – which means less people spending and buying assets.
It’s an issue recognised by many bond market experts, including Blackrock’s head of fixed income, Steve Miller, who believes that global rates will have to stay lower for longer.
“In this era we are more worried about deflation rather than inflation. Part of that is an ageing population story, if people aren’t working the supply side is simply not there,” he said.
“The US 10-year bond yield is at about 2.55 per cent and by year end that may head back up toward 3 per cent, while the Australian 10-year bond yield should outperform the US because monetary policy in Australia is going nowhere any time soon. I suspect we will stay around where we are now and the US will drop off a bit in bond terms.”
The strong performance of bonds in 2014 as the 10-year rate has fallen from 3 per cent to 2.5 per cent has caught many investors that were betting on US Treasury rates to rise as the US economy showed signs of recovery.Wave of mergers and acquisitions
The stock market by contrast has continued to gain, with the S&P500 and Dow Jones indices trading at historic highs during the week.
The rally in bonds has unleashed a wave of mergers and acquisitions, share buy-backs and increased dividends as companies use the low cost of debt and large cash balances to finance activity.
More than ten deals of over $US10 billion have completed so far this year as companies from Pfizer to General Electric look to put their money to work.
“What you are seeing now is remarkable pick up in activity,” said Jonathan Bader of Halcyon Capital.
“The reasons are obvious. Debt is cheap, and balance sheets are strong. Now CEOS have more confidence than they had a year ago. They were like deers in headlights and despite the same conditions they were not prepared to pull the trigger. That has changed,” he said.
York Capital’s Dinan said that low interest rates had created an “arbitrage” between the cost of debt and the cost of equity, which will result in the former being used to fund buying the latter.
“You are getting rewarded for using your balance sheet. If you are hoarding your cash and not using [cheap] debt you are being penalised because of the negative returns on cash. Anything you can do is being accretive.
BT Investment Management’s head of income and fixed interest said the tax advantages both in the US and Australia is partly why companies are gearing up their balance sheet to help offset earnings.
“Because of the low growth environment, companies are leveraging up their balance sheets at a similar pace to what we saw prior to the global financial crisis and using that to participate in share buy backs. Apple was a recent example of this. They they get tax relief for doing that.”
He added that the risk of an asset bubble is very real and could burst if economic growth were to slow abruptly.
Some hedge funds are warning that the slow-pace of normalisation in interest rates is storing up risk for a later date.
“No one even the Fed knows where rates are going but with the 10 year where it is, it seems like the risk is to the upside,” said Halcyon Capital’s Bader.
“If they do go up it could be bad for some credit and equities,” he said.
Deepak Narula said low bond rates had “surprised many people this year”.
“You have to have a scenario where they pull back on quantitative easing and forward guidance but that wont happen in a vacuum. There needs to be signs of inflation,” he said.
Narula warned that persistently low rates “presented real risks” as less credit worthy borrowers became accustomed to low-interest rates.
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