Behavioural finance is often associated with looking for instances of overconfidence. Most examples show that human beings are too pessimistic or optimistic, or simply understate the chance that we will be surprised. But sometimes we can also observe instances when confidence is unusually low. This is what I believe we can see in government bond markets today.
Where we had previously seen relatively fierce debates over whether interest rates in the developed world were to be ‘lower for longer’ or were heading ‘back to normal,’ today that debate seems to have gone quiet.
Irrespective of whether the Fed increases rates by a small amount in September, December, or later, confidence in coherently arguing a case about the level of any kind of long-term equilibrium has collapsed. As we have noted before, while the secular stagnation thesis is still being proposed, its arguments remain inconclusive (Ben Bernanke outlined his concerns with the theory on his blog).
However, signs of capitulation are even more evident from the ‘normalisation’ camp.
You can see this clearly in the infamous ‘dots’ used by the Federal Reserve. While we attempt to pay as little attention to these forecasts as possible, there is something interesting going on with regards to the committee members’ long term projections. In 2012, the vast majority thought that the long- term rate should be at 4% or above. Three years later that situation has completely reversed (see figure 1).
You can see the gradual drift down when you look at the projections of each individual member.
This trend echoes our own experience. Each quarter we meet with various investors from across M&G and Prudential to discuss our views of the investing world. At these meetings we like to ask people’s long term views on the returns that should be expected from various asset classes.
The long term is useful because it gets to the heart of our subjective biases; once the time horizon extends beyond two years there is very little you can truly know and so changes in these beliefs often reveal more about feeling than information. At our last quarterly meeting it was notable not only for the continued drift down in long expectations for real rates, but also the general sense of ‘tiredness’ with the debate.
This ‘tiredness’ often happens in markets when people lose their sense of what the fair value for an asset is, what we refer to as ‘anchors.’ People may originally think they have identified mis-pricing but then price action contradicts them for longer than they expect. They talk about bubbles, then more bubbles, then get confused when the bubble hasn’t burst, and then give up in a vacuum of coherent thought.
There was a similar dynamic at work during the dot com boom. As technology stocks continued to go up in the late 1990s there was a growing sense that the old rules of equity valuation no longer applied. As fund managers who had taken the other side of this bet and underperformed were either fired or ignored, this effect was magnified.
Today there is a similarly low level of conviction anywhere about where bond yields ‘should’ be. At a recent conference in New York, Mike Dooley, formerly of the Federal Reserve and IMF, compared the situation for policy makers to one in which not only are you unsure of where you are on the map, but you can’t even be sure that the terrain hasn’t changed.
When markets have these types of loose anchors, prices can go anywhere, and this is what I believe we can see happening in the pick-up in government bond volatility of late.
In the US, bond volatility is up at levels only topped in 2008 and in the midst of the Euro crisis. In Germany, levels are at their highest for 20 years.
Higher volatility in total returns is an inevitable function of low yields, since the coupon payment provides less of a cushion. However, I believe that the nature of recent price action also reflects what happens when long-run ideas about what’s plausible for bond yields and other assets is contradicted for longer than expected. This in turn morphs long-run views and investors can end up adjusting beliefs without realising it. Incidentally, it is this dynamic that provides some of the justification for the success of momentum strategies, as the market takes a long time to adjust to a ‘new normal.’
It is interesting to consider what manager experience means for these anchors. Earlier this year, Defaqto suggested the average tenure for a multi asset manager was six years. Tenure is not the same as experience of course, but this would suggest that many managers have only managed their fund in an environment of ultra-low interest rates (they were cut to 0.25% in the US in December 2008). Even fewer will have experienced an actual rate increase in the US; the last was in June 2006.
Does this mean that these managers are more suited to a new low rate world? Or does it mean they have less of a sense for a true range of possible outcomes that are out there? It remains to be seen. However in my experience, signs of a capitulation of views and a relaxing of anchors can often precede big market moves in either direction.