The End of the Bull Market in Bonds? (November 2016)

November 2016 Markets

The FTSE share index fell by 2.45%. UK gilts fell by 0.97% and gold fell by 8.15%. In the US shares fell immediately following the election result but rallied for the rest of the month in anticipation of economic stimulus from the new President, the S&P closing up 3.42%. Oil fell sharply but closed the month up 3.87% after OPEC agreed to cut production.

Trump Fallout

With hindsight, despite our overall defensive stance and high cash level, we were not brilliantly positioned for the Trump win. Although we had a suspicion he might snatch the vote, we did not foresee accurately all of the market impacts. After the initial shock, investors focused on 2 of Trump’s main election pledges. The first was his apparent hostility to imports from other countries and the second was his promise to spend money on new infrastructure projects.

From a market point of view the first order consequences of these policies were for the Dollar to rise and bond markets to fall. (More details below.) We were fairly neutral in the Dollar and had a low weighting in bonds, so these moves did not harm us. But the second order effects were for some of our European shares to fall (presumably under a fear of doing less business with the US in the future?) and for gold to fall, both of which did hurt us.

The case for gold is that it offers protection from high inflation and a degradation of the money system through money printing. But in the short term the case against gold is that it produces no income and therefore when compared with income generating assets such as bonds, whose yields just went up (see chart), it looks unattractive. This is not an absolute argument but a relative one, an argument of comparison. It tends to apply when income is real ie when inflation is low – and when the differential is widening. So with US 10 year yields rising by 33% from 1.8%pa to 2.4%pa in the space of one month, gold suddenly looked unattractive on an income differential basis and some investors chose to sell.

Gold had a bad November

Click the image to expand


US 10 year yields rose by 33% from 1.8%pa to 2.4%pa in the space of one month

Click the image to expand


Is this the End of the US Bond Super-Cycle?

Both of the charts immediately above and below are of the US 10 year interest rate (white line), just with different scales. The above chart is for the last 6 months and the below chart goes back to the 1960’s. The November 2016 rise is barely visible on the 50 year chart but we think it could turn out to be the inflexion point breaking the 34 year downtrend. This is quite a brave call to make, but we are making it. If so, it would have material implications for all other investments.

US 10 year yields going back to the 1960’s (white line) together with the US Inflation Rate (mauve line)


A super-cycle looks like this chart. Interest rates (white line) rose steeply in the 1970s in lockstep with rising inflation (mauve line), which was at that time itself the result of a weak Dollar (following its detachment from gold in 1971), the oil crisis in the Middle East, high government spending on foreign wars and strongly unionized labour markets. But once Paul Volcker was put at the helm of the Federal Reserve the inflation problem was addressed, permitting bond yields to decline. They peaked in 1982 and have fallen ever since – until now, perhaps.

The various financial crises of 1987, 2000, 2008, and 2011 were each met with the same response from Central Banks which was to lower interest rates at the short end so that the economy might be gassed up for a credit driven recovery to follow. These recoveries did follow but became weaker and weaker. It was notable and to us at least, surprising, that they took place without inflation picking up. Why it did not pick up is a question for another time but suffice it to say that there have been a number of changes in the way the figure is calculated over the years, each of which has made the figure lower than it would have been.

Suffice also to say that each time an emergency low interest rate was set in order to fire the economy, it was never put back to its previous level again once the recovery materialized. The reason for this (as we have written in the past) is that fueling the economy with debt does not really bring about genuine recovery, only the illusion of recovery, whilst leading simultaneously to all sorts of other distortions such as the decline of the middle class, falling median real incomes, an increase in wealth inequality, mal-investment and ultimately electoral and social unrest. What each gassing-up did achieve though was a boost to share and property markets which entered a series of bubble phases. Interestingly, Mario Draghi, head of European Central Bank the other day denied that his policies has these consequences – but produced no evidence.

As mentioned, throughout this period government, corporate and private debt levels rose continuously. US government debt outstanding (mostly represented by US bonds) now amounts to some $20trn or 107% of US GDP. (By some estimates the real figure is about 3 times this amount when various additional government pledges are counted in among its liabilities.) To keep issuing new debt you have to find people who will lend you the money.

So far, on the surface it would appear that there has been no shortage in the number of people who were willing to lend money to the US Government at low prevailing rates of interest but when you look in more detail, this is not quite the case. First, about 40% of outstanding government debt is owned by other government agencies including the US Central Bank (which prints the money and then “lends” it to the government) and social security and government retirement funds. In other words, the government owes money to itself.

Secondly, about 30% of the government debt is held by foreign governments and investors and among these, the Chinese dominate. Since the 1980’s when China started to emerge from the economic wilderness and began making and selling things to the US, it was happy to accept US IOUs for these sales. (Actually it used the Dollars it was receiving from selling products to buy US government bonds thereby lending the Dollars back to the government.)

The reason for explaining this point in detail is to justify the call for the trend change in the 34 year down cycle. Trump has declared he would like to provide incentives for production to be brought back from China to the US – whatever they may be. That could mean lower trade with China and fewer Dollars paid to Chinese exporters. Independently of this, the Chinese have been reducing their holdings of US Treasuries throughout 2016 for other reasons. Their own economy has weakened and it is possible they want the money for other things. So this particular source of bond buying is dwindling.

In addition, Trump has announced that he would like to cut taxes while at the same time spending more on infrastructure to “boost the economy”. (More below.) By cutting taxes while simultaneously raising spending, Trump is by definition intending to borrow more and in order to find new lenders as previous sources of borrowings dry up, all things equal, the interest rate on offer will have to be higher. On the other hand if rates on offer are kept low and third party buyers cannot be found then the Central Bank will once again need to step in and absorb the debt with newly printed money. This would probably be inflationary. They would need to launch quantitative easing 4 and while the previous QE’s have indeed not led to a tick up in the CPI, we guess that QE4 probably would do. Any increase in the CPI (or rise in the mauve line) would ordinarily be accompanied by a rise in the white line with a time lag, hence our call that either way, long bond yields are probably now on their way up following 34 years of decline.

This yield change would have consequences for other types of investment. As we have seen, gold fell because of the relative income differential widening. Likewise, shares and property could be expected to fall because the return differential versus the “risk free” return on US bonds would have become more unfavourable.


There is a conventional view that infrastructure is good for the growth of a country. Keynesians like to point to the jobs created in building say a bridge but this is a flawed way of looking at things just as all job creation schemes are. It would be cheaper to pay the workers to do nothing than to pay them to build a bridge which wasn’t needed. The question to be asked is what returns the bridge will yield in the future – direct and indirect – and how they compare with the total costs of constructing AND MAINTAINING the bridge. (Maintenance is so often forgotten because it is not sexy and it is a continuing burden).

This is clearly difficult to analyse because costs and benefits cannot be isolated precisely. In addition to the direct and visible costs and benefits (even if they were calculated properly which they are not) there will always be indirect and invisible ones. There is also the subject of externalities which is particularly acute in the case of infrastructure. Only rarely are the people who pay the cost the same as the ones who benefit eg living near a new road confers costs to you without an associated benefit. This is true whether overall benefits exceed or are less than overall costs. So the blanket cry that infrastructure is good must be challenged.

A particular curiosity about infrastructure is the timing of costs and benefits. Some costs are obviously immediate but as mentioned there is also a long tale of maintenance and repair which are often overlooked. But this can apply to the benefits too. Sometimes expected future benefits can disappear because of new technology (eg the UK canal network’s prime was actually quite short because of the advent of the railway) but equally something producing little benefit at first can pay for itself many times over in later years. The best example of this is the pyramids of Egypt which have generated billions in tourist revenues in the last 100 years alone, some 4000 years after their construction bankrupted the Egyptian economy. Who knows? Perhaps London’s Olympic stadium will be a cash producer in a thousand years’ time after all.

In reality, most infrastructure projects present a burden upon an economy, Some of them cover this burden handsomely but it is not guaranteed, so Trump should not get too carried away. Most would agree though that infrastructure is terrific if you can get somebody else to pay, as seems to happen across Europe.

EU Infrastructure Funding

For over a year we have listened to the debate on membership of the European Union. Across the Continent voters in Austria (Dec 2016), Netherlands (Mar 2017), France (June 2017) and Germany (Sept 2017) are about to express their views on the subject at the ballot box.

Few people will have taken the time to review the EU’s accounts to help them with their decisions. It might help them if they did although it must be said that they are not so easy to read.

This is the full Budget document for 2015

These are the Financial Accounts

In particular they use quite misleading labels to describe the various categories of expenditure. The infrastructure projects which I was looking for are captured under a variety of headings including “Competitiveness for Growth and Jobs”, “Economic, Social and Territorial Cohesion”, “Regional Convergence”, “Competitiveness – developed regions” and so on. I shall not do the official financial statements justice in this report but I show the 3 charts below and I make the following comments.

Summary of Total Budgeted Payments for 2015.


Category 1A Competitiveness for Growth and Jobs and 1B Economic Social and Territorial Cohesion contain the infrastructure projects which I was looking for and Category 2 Sustainable Growth, Natural Resources includes the Common Agricultural Policy. Category 5 yellow is Administration which can be thought of as the management fee for running the EU and is currently 6% of the total.


The total budgeted revenue of the EU for 2015 was €146bn. The chart below shows who was designated to pay it. The UK is anomalous because of its rebate which is netted off against the sums due from the UK and is effectively allocated to the other countries. Even after this rebate, for information, the UK is the 2nd largest payer into the EU’s coffers.

Contribution to the EU Funds by Member Country


Although you wouldn’t be able to work this out from the colour coding and labels on the above chart, about two thirds of the money is written over as a cheque out of the Treasuries of each member state. The rest is made up of VAT receipts collected on behalf of the EU by member states under a formula, tariffs charged to foreign countries eg the US exporting to the EU and special payments from non EU countries (we think this means Switzerland and Norway). 1% of the EU’s revenue comes from fines which is quite astonishing.

Expenditure out of EU funds by Member Country

The subject of who gets what out of the EU is much more difficult than the analysis of who puts what in. The payments in are factual but those out can be direct or indirect and involve other issues. But according to the EU’s own documents this is what the expenditure/recipient schedule looks like. To take the first column as an example, France receives €14.0bn out – bottom chart – having paid €19bn in – top chart – so is a net payer of €5.0bn according to these numbers. The UK is a net payer of €13.9bn according to this (€21.4 – €7.5). On the whole the core EU members are net contributors and almost all the newer members/Eastern European countries are net beneficiaries.


The total money spent in 2015 (budgeted) was €141.5bn. At €66.5bn, nearly half – shown in sections 1A and 1B (orange and red) with nonsensical labels – relates to money aiming to achieve growth, competition, innovation etc including infrastructure. It is aiming at helping the weaker members. Most of this budget (orange and red lines above) is spent by Poland, Czech, Spain, Italy, Hungary, Romania and Slovakia.

Some of the projects make a lot of sense eg energy and telecoms and some transport, while other projects are clearly flawed. For example the EU financed the construction of 3 airports in Poland which hardly anyone flies to, not least because they are too close to other older established airports. They have not been closed yet so they continue to drain funds. One of them has 4 light arrivals per day.

Included in this innovation category there appear to be about a million projects with no particular common theme. All sorts of things seem to be eligible to receive EU funding, some good, some doubtful. By way of example I found 2 projects which in fact do have a common theme.

1.“Graphene-enhanced aircraft flies”


And this one:

2.“Airlander 10: World’s largest aircraft crash lands second flight”


For information, at €56.6bn the second biggest item of expenditure out of the total EU budget is the Common Agricultural Policy represented by the grey lines in the above chart. France, Spain, Italy, Germany and Poland are the biggest beneficiaries of this programme.

Summary and Conclusion

Markets are unsettled by election turmoil and by the higher likelihood of long term interest rates rising following 34 years of declines.

In the near future the US will increase its borrowings to finance planned infrastructure developments while Europe has open ended commitments to build out its eastern members.

Government debt levels are already high and the demand for new loans should finally start to push rates up. (Although we concede that this has not been the case in the past years.)

It is not certain that infrastructure leads to economic growth. Perhaps it will, perhaps it won’t. Against this, all things equal, rising interest rates will put pressure on growth.


Please click here for a printable version of the report