Matthew Feargrieve is an investment management consultant with more than twenty years’ experience of advising managers of investment funds operating in the leading jurisdictions of the United Kingdom, Luxembourg, Ireland and the Cayman Islands. His extensive experience of advising fund managers makes Matthew a valued member of the boards of investment funds in various jurisdictions, on which he acts in a non-executive capacity.
Before becoming an independent financial services consultant, Matthew worked for leading financial services firms in the UK and in Switzerland. Learn more about Matthew Feargrieve here.
Investment management consultant MATTHEW FEARGRIEVE discusses the relationship between rising yields on US Treasuries and the fortunes of Gold and Bitcoin.
By 17 March the financial markets were clear about one thing: that the Fed intends to run the US economy hot.
At its 17 March meeting, the Federal Open Market Committee (FOMC) upped its inflation forecast from 1.8% to 2.4% for 2021, whilst simultaneously keeping interest rates nailed to the floor; the Fed has indicated that no rate increase is likely until 2023 at the earliest.
By raising its 2021 inflation target to 2.4%, in tandem with maintaining its commitment to a massive economic stimulus spending, the Fed has clearly signalled the US government’s willingness to tolerate a short-term rise in inflation as an acceptable price to pay for post-pandemic economic recovery.
And so, just at a time when the US government is issuing large volumes of government bonds (aka US Treasuries) to fund this spending, the spectre of inflation appears on the horizon.
The effect of these two things – more bonds in issue, plus the prospect of inflation eating away at the returns on longer maturity US Treasuries – has led to the recent surge in bond yields, by which investors demand higher returns to compensate them for the risk of inflation. These higher yields accordingly increase the cost of borrowing for the US government.
We suggested in our earlier piece Why Bond Yields will Climb Further that it would be unwise for investors to assume that the Fed intends this inflationary period to be purely transitory. More than a year of economic lockdown has left the world economy in need of massive stimulus and spending programmes to help it reflate. We know nothing about the extent of the Fed’s capacity to tolerate prolonged inflationary pressures before it will feel compelled to take normalising action. Raised levels of inflation could well be higher and longer-lived than we would prefer to believe.
The more real the prospect of a new era of inflation dawning, the higher bond yields will rise. The Fed has not shown itself particularly willing to curtail rising yields by buying back Treasuries. True, there is some repurchasing going on, but this is outweighed by the volume of new bond issuances as the US government pursues its goal of spending its way out of economic trouble.
Bond Yields & Gold
The world’s most trusted precious metal has had a bad start to the year. After mid-pandemic highs in 2020, vaccine roll-outs are now renewing investor confidence and the price of gold, a traditional safe haven in turbulent times, has fallen by 9.6% in US dollar terms over the first three months of 2021.
Figures released this month by the World Gold Council show that central bank gold purchases, one of the key drivers of demand, have tumbled in 2021.
Gold has suffered in part from growing optimism about the global post-pandemic recovery, but also from rising bond yields.
Higher yields on US Treasuries are bearish for precious metals because investors can earn guaranteed returns from the yield at lower investment cost (the bond price), unlike metals which fluctuate in price and do not generate any income (interest, dividends).
We think the 2021 challenge for gold prices is twofold: economic recovery and higher-than-normal bond yields, which will be attractive both to institutional investors, who can realise more income from US government debt than from precious metals, and to retail investors, who are already trimming their gold exposure in Comex and ETFs.
Despite historical correlations between rising bond yields on one hand, and gold and Bitcoin on the other hand, Bitcoin is bucking the trend whilst gold sunk to a one-year low of US$1,678 per ounce on 8 March.
Following the conclusion of the FOMC meeting on 17 March, crypto investors watched nervously for an increase in Fed bond buyback activity, intended to curtail rising bond yields. Analysts had been warning that a fallout from bond yields could lead to a correction in riskier assets like Bitcoin.
Rising yields dilute the appeal of Bitcoin as a perceived inflation hedge just as much as they do gold’s. In February Bitcoin showed itself to be sensitive to bond yields, when prices fell by 20% after the US 10-year Treasury yield rose sharply to a year-high of 1.6% (this being some 2.3% higher than the yield on 10-year Treasury Inflation-Protected Securities, or “TIPS”, compared with a gap of just under 2% at the end of 2021; an increase that highlights market nervousness about inflation returning).
After the FOMC meeting, the 10-year Treasury note yield went higher, to 1.74%, as markets began to digest the Fed’s message that it was prepared to tolerate inflationary conditions for the foreseeable future.
There is an irony here. Just as inflation may escalate, once more consumers start spending again, and Bitcoin looks like coming into its own as an inflation hedge, it is rising Treasury bond yields that could create extra selling pressure for the cryptocurrency.
Indeed there was some Bitcoin sell-off between 17 March to month-end when the Fed showed itself to be reluctant to step in to curtail rising yields. Thereafter, though, Bitcoin prices rose again. Bitcoin bullishness seems so far to be immune to rising yields, helped no doubt by continuing institutional take-up.
There is a caveat to this bullishness. Bitcoin may face selling pressure if yields rise at a faster pace, which would destabilize stock markets. Gold, as a traditional, stable safe-haven, would benefit if the markets were spooked in this way. Crypto, as a risky asset, would not.
That said, a number of big market players (like Goldman Sachs) expect equity markets to be able to absorb a 10-year yield of around 2% without much difficulty.
During previous episodes of yield spikes, institutional participation in Bitcoin was lower and the cryptocurrency was largely an uncorrelated asset. Times have changed. So Bitcoin’s rise could indeed be unchecked by prolonged high yields.
Sell Gold and Buy Bitcoin?
We posited earlier in this piece that the challenges for gold for the rest of 2021 will come from continuing economic recovery and government bond yields staying high
We must consider a third challenge for gold – the rise of crypto as “digital gold”.
It may be that an additional dynamic driving gold prices lower is the increasing number of investors opting for crypto as digital gold – a digital hedge against inflation – instead of the precious metal, not only because of the higher upside potential but because crypto positions can be liquidated much more easily than physical or derivative gold positions.
Whilst the jury is out on whether rising bond yields will curtail the rise in Bitcoin prices, Bitcoin’s place as an increasingly important player in the macroeconomic environment may well help it to ride out the yield curve and consolidate its role as a hedge against inflation. This would enable it to eat away at gold’s market share.
We do not consider that this is the time to exit gold completely. The lingering whiff of inflation, combined with the potential for higher unemployment on both sides of the Atlantic once furlough schemes are withdrawn, are strong dynamics that tend towards retaining some exposure to gold.
And remember, gold could benefit from both a rise in bond yields and a drop. When US Treasuries pay lower returns, investors will trim their bond holdings and move money back into gold and other precious metals, which will drive prices up. Conversely, a spike in bond yields could give markets a big dose of the inflation jitters, and trigger a shift from the dollar to gold as a safe haven. This was seen in the 1980s when yields soared upwards toward 14% and gold also spiked. Bitcoin, still a risk asset, will not benefit from a flight-to-safety like this.
As for buying Bitcoin now; why would you? We do not feel that Bitcoin prices can go much further (although we were proved wrong about this in Q3 last year). The price surge is starting to have “bubble” written all over it.
In the absence of some significant crypto catalyst, such as legislation in the US that would facilitate a Bitcoin ETF, or a new large tech player entering the crypto economy (and, no, we do not consider the Coinbase IPO to be such a catalyst), there is, we think, little fundamental support for a new Bitcoin rally in the short term, particularly if recovery optimism is sustained and equities maintain their current levels of attraction for retail investors.
Investment management consultant MATTHEW FEARGRIEVE considers the outlook for Gold prices in Q2 2021 and beyond.
The world’s favourite precious metal hit a record high of US$2,069.40 per ounce in August 2020, driven by weakness in the value of the US dollar as low interest rates and government economic stimulus during the Covid-19 pandemic sent investors toward precious metals.
At the height of the pandemic in 2020, when investors were flooding into safe-haven assets, many professional investors optimistically predicted gold would head towards, and smash through, US$3,000.
But it was not to be. As vaccine roll-out got underway, and stock markets sustained their buoyancy, investor confidence returned. Gold being a traditional flight-to-safety asset in turbulent times, investors began to trim their positions, and the price of gold has fallen by 9.6% in US dollar terms over the first three months of 2021.
The price dropped to a one-year low of US$1,678 per ounce on March 8, then rebounded to US$1,743.90 per ounce, before slipping back to US$1,686 per ounce on March 30. It managed US$1,728.40 per ounce on April 1 as the Biden administration announced its US$2trn infrastructure spending plan.
Gold price forecasting for 2021 has been adjusted downwards somewhat, with many estimated averages hovering around the US$2,000 mark. Some players predict lower. Citibank, for example, posit that the bull market cycle for gold has ended. They have cut their average gold forecast for 2021 from US$1,900 per ounce to US$1,800 per ounce.
Gold has been conspicuously absent from the recent commodity rally, suffering US$1.1bn of outflows in the last week of March.
And figures released this month by the World Gold Council do not improve the 2021 outlook for gold. The figures show central bank gold purchases, one of the key drivers of demand, have tumbled in 2021.
Collective net purchases totalled 8.8 tonnes, with India buying around 11.2 tonnes, Uzbekistan 7.2t, Kazakhstan 1.6t, and Colombia 0.5t. But offsetting this was Turkey which sold 11.7t, putting central bank net sales at 16.7t year to date, which is the weakest start to a year in a decade.
If gold is a safe asset in hard times, why did its price rise on news of Biden’s stimulus measures? The question can be answered in one word: inflation.
The more the US government spends on stimulus packages, the more the prospect of increased spending by hundreds of millions of locked-down, frustrated consumers, the greater the market’s expectation of higher levels of inflation.
At its March 16-17 meeting, the Federal Open Market Committee (FOMC) forecast inflation running to2.4% this year, ahead of its previous estimate of 1.8%. It also stated that interest rates in the US are to stay on the floor, with no rate increase likely until 2023 at the earliest.
Here we have two market dynamics that impact gold prices: high(er) inflation and low(er) interest rates.
Higher inflation (combined, in an ideal scenario for gold investors, with higher unemployment) is broadly good for gold. Low interest rates mean that gold, a non-income generating asset, can in principle stay competitive.
Post-the FOMC meeting, there is now in the US a low-interest rate, low-inflation environment. .
There is, however, the spectre of inflation on the horizon. The Fed acknowledged this by raising its 2021 inflation target to 2.4%. It signalled the US government’s continuing commitment to spending its way to post-pandemic economic recovery and that it is prepared to tolerate a short-term rise in inflation in the process. So the Fed is determined to run the US economy hot. A highly-stimulated reflationary economy, combined with the unleashing of pent-up consumer demand, is a recipe for higher inflation.
So why are gold prices dropping when inflation may be making a comeback? The answer lies in the bond markets.
The potential for higher inflation has, in part, driven bond prices down. Inflation effectively reduces the returns of bonds over time, and the price that the US government can demand from buyers of its long-maturity debt instruments (aka US Treasuries) has accordingly fallen.
Falling bond prices drive bond yields higher, and higher yields make borrowing more expensive for the government that issues the bonds. So we can expect some intervention by the Fed if bond yields continue to climb. But at the moment the Fed is determined to persevere with its stimulus spending programme, and US Treasuries are still being issued in large quantities.
Because bonds are sensitive to the effects of inflation, they are the one asset that acts as an early-warning system when inflation is on the horizon. So low bond prices mean better times for gold prices, right?
Well, not quite. Downward pressure on bond prices has the opposite effect on bond yields. Higher yields on US Treasuries are bearish for precious metals, because investors can earn guaranteed returns from the yield at lower investment cost (the bond price), unlike metals which unlike bonds fluctuate in price and do not pay interest or dividends. Higher yields also attract foreign investors, supporting a higher US dollar, which in turn has a depressive effect on metal prices.
We explained in our blog Why Bond Yields will Climb Higher that we should not assume that the Fed intends the current inflationary phase to be purely transitional. We know nothing about the extent of the Fed’s tolerance of persistent inflationary pressures before it will feel compelled to take normalising action. After more than a year of economic lockdown, the world economy needs big stimulus and spending programmes to help it reflate. Inflation may be higher and longer-lived than we may think.
Longer-lived inflation will, we think, keep bond yields high. The Fed has not shown itself particularly willing to curtail rising yields by buying back US Treasuries. There is some repurchasing going on, but this is outweighed by bond issuances.
In short, we think the 2021 challenge for gold prices is twofold: economic recovery (with or without an attendant investor influx into equities, which we are already seeing) and higher than normal bond yields, which will be attractive to both to institutional investors, who can realise more income from US government debt than from precious metals, and to retail investors, who have trimmed their gold exposure in Comex and ETFs.
One thing that could keep gold in the game is the absence of consensus on the likelihood and degree of inflation risks. Investors are aware that worldwide policymakers like the Fed have been downplaying the risks, so as not to spook consumers into curtailing their post-pandemic spending. If inflation overshoot expectations, risk-conscious investors will return to gold.
Investment management consultant MATTHEW FEARGRIEVE explains why his account problems at Coinbase make this crypto exchange’s initial public offering a distinct turn-off.
Cryptocurrency exchange Coinbase has been offered to the public on the US tech index Nasdaq with a valuation of US$99.6bn. The valuation, which surprises some commentators, has been taken by many industry players as another confirmation that the more crypto as an asset class goes “mainstream”, the greater the confidence investors have in it.
As Bitcoin prices continued to fly high, Coinbase shares opened at US$381, well above Nasdaq’s US$250 guidance price, before falling to close at US$328. This gives the company a market capitalization of around US$85bn. To give you some size comparison, Facebook is currently worth around US$900 billion. So, not a bad start for a cryptocurrency exchange.
The soaring price of Bitcoin, and the way in which the Coinbase initial public offering (IPO) exceeded analyst expectations, are by no means coincidental. It is no overstatement to say that crypto is booming.
Its leading protagonist, Bitcoin, has been smashing through ceiling after ceiling since mid-2020. When Coinbase was first set up, Bitcoin was priced in single-digits. Its price recently broke through US$64,000.
Exponents of cryptocurrency are hailing Coinbase’s Nasdaq listing as a significant milestone in the global validation and acceptance of crypto as an increasingly “mainstream” asset.
In the space of just a few months during 2020, Bitcoin’s price surge saw a spike in the amount of the cryptocurrency moving into North America and East Asia, and its growing take-up by compliance-wary US investors.
Bitcoin was no doubt propelled during 2020 by allocations by hedge funders Paul Tudor Jones and Stanley Druckenmiller , as well as Grayscale and JP Morgan. In October 2020, PayPal announced that it had pivoted to implement the acceptance of cryptocurrencies on its US payment platforms. As we move into the second quarter of 2021, and with the end of the Covid-19 pandemic in sight, institutional allocations to Bitcoin and other cryptocurrencies show no signs of letting up.
So why won’t I be buying any shares in Coinbase?
For many Coinbase users, amateur and professional alike, Q4 2020 and Q1 2021 was a painful time. Bitcoin prices it seemed could only go up and many crypto investors big and small wanted to join the ride.
It was at precisely this critical time that Coinbase users were locked out of their accounts, and so were effectively excluded from the Bitcoin party.
Regular readers of this blog will remember my frustration when I gave an account of my own problems at Coinbase. I explained how the California-based exchange, the world’s biggest for Bitcoin, is popular with small investors (like me), who are able to buy Bitcoin with smaller sums of money than the thousands of professional traders who use it every day. I explained how we all rely on the exchange being fully accessible and operational at all times, service which was assured to us when we signed up.
So it was deeply frustrating, during late 2020 and early 2021,to be told that our accounts were suspended “pending review”, despite having submitted the customary ID and know-your-client (KYC) proofs and documents when we opened our accounts.
Customer frustration turned to anger the longer Coinbase kept their accounts in suspense. Things culminated in January in a public statement by Coinbase that fell just short of an actual apology:
“As a regulated financial services company, we’re required to maintain rigorous compliance standards in line with other financial institutions in the UK. To ensure compliance with recent regulations, we’ve had to seek additional documentation or information from some customers. While we appreciate that this is a burden for some, it’s our responsibility to meet the standards set by regulators.”
This was little comfort to those of us who wanted to buy Bitcoin during the dip in December, but were unable to do so because Coinbase had locked us out of our accounts.
As I asserted in my blog My Coinbase Woes, this major service failure did nothing to assuage the worries that traditional, mainstream management firms, as well as smaller investors like me, continue to have about the operational soundness of crypto systems. These worries in turn lead to reservations about how safe our deposits are, and the extent of our ability to realise returns and mitigate losses using crypto and blockchain technologies.
As a user of Coinbase, with money on deposit, I (like thousands of others) had a terrifying, dawning realization that I was a hostage to a double-whammy of anxiety: one operation, the other regulatory. Coinbase had effectively been forced to confess in a public statement that its operations were being subjected to more regulatory scrutiny.
And therein lies, for me, the big problem with Bitcoin and other cryptocurrencies. Not the scary price volatility (that hasn’t gone away, by the way – it’s still embedded in the asset). Not the limitations of the technological infrastructure and support systems (although these are, of course, big turn-offs for many would-be crypto investors). But the looming financial and legal regulation that is headed crypto’s way.
So it was that I found myself pulling my hair out in frustration in December and most of January, unable to access my Coinbase account, unable to withdraw funds, unable to buy or sell Bitcoin. And then, to make matters worse, the UK’s financial regulator, the FCA, issued this statement:
‘The FCA is aware that some firms are offering investments in cryptoassets, or lending or investments linked to cryptoassets, that promise high returns. Investing in cryptoassets, or investments and lending linked to them, generally involves taking very high risks with investors’ money. If consumers invest in these types of product, they should be prepared to lose all their money.’
This warning, the starkest of any financial regulator yet issued about cryptocurrency, came only a day after regulations came into force in the UK requiring cryptocurrency firms to comply with anti-money laundering rules.
It is obvious from its statement that the UK financial watchdog is concerned that some crypto firms do not yet face any formal regulation in the UK beyond basic AML and KYC requirements.
This regulation is most assuredly on its way. And this, together with my unhappy experiences as a Coinbase user, dampens my enthusiasm for the company’s IPO.
Indeed, the very fact of Coinbase being offered more widely to the public will usher in this regulatory scrutiny, which in turn will acts as a significant drag on its balance sheet.
More generally, cryptocurrency and players like Coinbase will pay the price for the meteoric rise of Bitcoin and the influx of investors. The more cryptoassets look as if they are being embedded in the global financial system, and the more they achieve a wider investment base through public offerings and exchange-traded funds (ETFs), the more investors must expect governmental and regulatory scrutiny. (See also Bitcoin ETFs: providing Public Access to a Bubble Asset?)
The unhappy experience of Coinbase users compounds two of the three biggest drawbacks of Bitcoin and cryptocurrencies: one operational, the other regulatory. The third drawback being, of course, its infamous volatility.
These three primary sources of risk for any investment in cryptocurrency will increasingly become the focus of the FCA and other financial regulators worldwide over the course of 2021, an inevitable process that will only be accelerated by a sustained rise in crypto prices and investor influx.
MATTHEW FEARGRIEVE is an investment management consultant. You can read his investing blog here and see his Twitter feed here.
Investment management consultant MATTHEW FEARGRIEVE asks if Peter Thiel, PayPal co-founder and crypto investor, has a point when he says that the world’s most popular cryptocurrency could be considered a “Chinese financial weapon against the US” – and, for that matter, the rest of the world.
Just as Bitcoin was hovering around US$56,000 over 6-8 April, before climbing back to over US$64,000 a week later, Trump loyalist and crypto investor Peter Thiel was addressing the members of the Richard Nixon Foundation at a virtual event.
Thiel was joined by former Secretary of State Mike Pompeo and former National Security Advisor Robert O’Brien. The conversation between Thiel, who has frequently criticized American companies that do business with Beijing, and these former members of the Trump administration, was largely focused on US-China relations.
Billionaire Thiel, who is a major investor in virtual currency ventures as well as in cryptocurrencies themselves, now thinks that Bitcoin has the potential, in Chinese hands, to undermine America’s security and its place in the world order.
Thiel explained why the Chinese dislike the US Dollar being the major reserve currency. “From China’s point of view, they don’t like the U.S. having this reserve currency because it gives the U.S. a lot of leverage over Iranian oil supplies and all sorts of things like that. [Bitcoin] threatens fiat money, but it especially threatens the U.S. dollar, and China wants to do things to weaken [the Dollar].”
He added: “[If] China is long on Bitcoin, perhaps from a geopolitical perspective, the US should be asking some tougher questions about exactly how that works.”
Attendees at the event held their breath as Thiel concluded: “I do wonder whether at this point, Bitcoin should also be thought [of] in part as a Chinese financial weapon against the US.”
If we take Thiel’s remarks at face value, they represent something of a departure from his previous publicly-made statements about Bitcoin’s qualities and attractiveness as an investment asset. But we need to add some qualifications to the substance of what he said, before we decide what credence to give his remarks.
Thiel described himself at the event as being “pro-Bitcoin”, and he still holds significant positions in virtual currency ventures as well as in cryptocurrencies themselves. It seems unlikely that Thiel will shed his crypto investments, although his views on the sustainability of the current Bitcoin surge are unknown. And PayPal, which he co-founded, has onboarded Bitcoin (and other cryptocurrencies) as accepted currency on some of its payment platforms.
Perhaps the remarks he made at the Nixon event indeed signal something of a crypto-rethink on Thiel’s part. Perhaps he was just being philosophical. Perhaps he was just being deliberately provocative.
Whatever the truth of the matter, whatever his motivation for saying what he said, we need to ask: does his argument hold water? Could Bitcoin be used by China to undermine the US Dollar and US interests?
It is important to keep in mind the context in which Thiel was speaking. The Richard Nixon Foundation and its members are, naturally, Right-leaning. His panel members with whom he was having this discussion were Mike Pompeo and former National Security Advisor Robert O’Brien, both hawkish members of the Trump administration. And Thiel’s own loyalty to Trump is well known.
Against this backdrop, Thiel may well have given his comments about China’s use of Bitcoin a little extra political umph. Would he have spoken about crypto in so openly geo-political terms at, say, an investors conference? Maybe not.
Having established the context in which Thiel was speaking about Bitcoin, we next need to examine the three premises that appear to underpin his comments: first, that Bitcoin could threaten fiat currencies; secondly, that Bitcoin could challenge the US Dollar as a major reserve currency; and thirdly, that China is, as Thiel put it, “long on Bitcoin”, in other words, holding it in significant amounts. Let’s examine these three propositions in turn.
Does Bitcoin have the potential to threaten fiat currency?
Fiat money is government-issued money that is not backed by a commodity like gold. Fiat money gives central banks greater control over the economy because they can control how much money is printed.
Bitcoin, like other cryptocurrencies, is like fiat money because it is not backed by any commodity or precious metal. It differs from fiat money in being a digital asset that derives its intrinsic value from blockchain (and the technological integrity thereof).
Fiat money on the other hand is a physical currency (paper notes and metal coins) that derives its intrinsic value from the stability and creditworthiness of the government that issues it.
If Bitcoin is a fiat currency, what are its advantages over the US Dollar? Thiel, as far as we know, did not elaborate on this at the Nixon event. But there is a degree of consensus about what are the notional advantages that crypto enjoys over traditional (or should that be mainstream?) currency. We say notional because there is far less agreement about whether they are in fact real advantages.
The main such notional advantage, that Thiel will no doubt have had in mind, is that cryptocurrency cannot be controlled by any central authority of any country, unlike traditional fiat currency, which can be controlled to some extent by the reserve bank of its issuing country.
Another notional advantage is that, unlike banking services that are required to support the flow of traditional fiat money, cryptocurrency like Bitcoin has no storage cost. This characteristic must seem very appealing to retail banks worldwide, which have hated cash deposits for some years now, necessitating as they do a vast and costly infrastructure of buildings, machinery and manpower.
The final key advantage that is relevant to Thiel’s remarks is, perhaps, the decentralized nature of crypto. Traditional fiat money is limited to the borders of their respective countries, hence the clunky and costly business of foreign exchange (FX). Bitcoin on the other hand, being decentralized, enables cross border transactioning of uniform value at no additional cost.
Here, then, are three key notional advantages of Bitcoin over traditional fiat money that support the proposition that Bitcoin has the potential to rival (and ultimately, to take this argument to its logical conclusion, to replace) fiat money.
Given that the US Dollar is a traditional fiat currency, the next question is:
Could Bitcoin challenge the US Dollar as a major reserve currency?
A reserve currency is a large quantity of currency maintained by the central banks of different countries and major financial institutions, to investment, transact, meet international debt obligations and to influence domestic exchange rates. A large percentage of commodities, such as gold and oil, are priced in the reserve currency, which means that other countries have to hold that currency in order to pay for those commodities. The price of gold is a key example, which is always done in US Dollars.
With these characteristics, it is obvious that any country that issues a currency that acts as a reserve currency for the rest of the world will enjoy a lot of influence and power, as will the currency itself. As a result of the Bretton Woods Agreement, the US Dollar was officially crowned the world’s reserve currency and was backed by the world’s largest gold reserves.
So does Peter Thiel have a credible point when he suggests that Bitcoin could challenge the US Dollar as a reserve currency?
Most economists are doubtful. The Bank for International Settlements said in January that the “dollar is the world’s premier reserve currency because it has a stable value (low inflation), a large supply of safe assets and the credibility of the US economic and legal system […] investors can also easily access the US’s deep and efficient capital markets, without worrying about capital controls […] These factors are likely to remain the primary drivers of global reserve currency status“.
Bitcoin does not share any of the qualities identified here by the Bank for International Settlements. It does not (notoriously) maintain a stable value, and the finite number of bitcoins means that it cannot keep up with global demand for safe assets, like the U.S. debt market can. Indeed, investor willingness to buy US government public debt, often at negative real interest rates, shows that the US Dollar continues to have massive appeal even as cryptocurrencies begin to show signs of going mainstream.
The recent rise in US Treasury yields, the spectre of inflation and the investor rush into inflation-linked TIPS, will all have an interesting impact on Bitcoin prices; for more on this, and the trajectory of Bond Yields in general, see our blog Why Bond Yields will Climb Further.
More fundmentally, there is a political element to the potential attractiveness of cryptocurrency to the Chinese Communist Party (CCP). We mentioned above that a key notional advantage that Bitcoin enjoys over traditional fiat money is that it cannot be controlled by any central authority of any country. This unique quality is something that, for the CCP, makes Bitcoin an interesting alternative to old fiat currency and the dominance of the greenback; this same quality is what also makes Bitcoin a deeply troubling proposition for the CCP.
China’s actions over the past decade show that it is deeply skeptical of Bitcoin and likely sees crypto as a threat to the power of the CCP. In 2017, the People’s Bank of China and five other ministries banned financings using cryptocurrency, and banned the exchange of fiat money for cryptocurrency.
Behind these state-imposed prohibitions (something to which many Bitcoin apologists claim crypto is immune) we can see China’s strict capital controls, aimed at preventing wealth from leaving China for other countries. To maintain these controls while allowing cryptocurrency transactions, Chinese banks would have been required to undertake what for them would have been a technologically impossible mission of tracking and imposing limitations upon each encrypted, anonymous cryptocurrency transaction from every Chinese user.
We may well speculate that Chinese banks are now receiving state funding to help them develop the technology to help them achieve this in the future. But the official view in China right now is (probably) that Bitcoin is a commodity, not a currency.
A state-led crackdown like this on decentralized, “ownerless” cryptocurrencies can hardly be seen as a move by China to promote Bitcoin as a competing reserve currency to the US Dollar. Thiel did not address this in his debate at the Nixon Foundation, nor did he acknowledge China’s homegrown digital currency, a digitalized yuan which has been developed over the past three years as a counterweight to popular digital payment platforms like AliPay and WeChat Pay, that have gained a toehold in China. This ditigalized yuan is issued by the country’s central bank (natch) and is undoubtedly designed in part to give the CCP more control over fiat currency changing hands in China.
Whilst Thiel’s remarks about China disliking the geopolitical power bestowed on the US via the greenback were entirely uncontroversial, it is harder to agree with his suggestion that a decentralized, borderless cryptocurrency could be embraced by a Chinese Communist Party that is bent on holding on to power and preventing foreign influence in China.
This brings us to the final question.
Is China Long on Bitcoin?
In 2020 China grabbed a South Korean based cryptocurrency exchange called PlusToken and seized a large volume of cryptocurrencies, including some US$3.3 billion worth of Bitcoin.
In January, data reports revealed that Chinese currency, out of all the G10 currencies, had the strongest statistical correlation to Bitcoin over the previous year, at around 84%. That means that any strengthening of the RMB against the US Dollar would translate into a similar gain for Bitcoin, 84% of the time. When the Renminbi rises, so does Bitcoin. By comparison, the same report showed that the Euro and the Ruble each had lower correlations with Bitcoin, at 74% and 25% respectively.
Of course, China’s role in setting Bitcoin prices is already well known. This may have been the central plank on which Thiel was building his remarks about China’s long positions in Bitcoin threatening the US Dollar – which argument supposes that crypto can ultimately come to rival traditional fiat currency, which we have just argued is doubtful.
Another thing to which Thiel may have been alluding is the fact that there are four miners in China that control over 50% of issued Bitcoin. This confers on China (or, more precisely, the CCP) the power to control the supply of coins in the Bitcoin market and to raise transaction fees based on mining difficulty.
China is also home to some of the biggest cryptocurrency exchanges for trading Bitcoin, like Binance. These exchanges have achieved high trading volumes and attract international retail investors by being cheaper to use than their foreign competitors.
So Thiel’s warning about China being long Bitcoin, and his suggestion that US foreign and economic policy should sit up and take more note of this, is probably best understood in the context of China’s dominant share of worldwide Bitcoin production, as opposed to how many Bitcoins the CCP currently holds.
How could China use Bitcoin as a Weapon aainst the US?
As we posited earlier in this piece, it may well be the case that Thiel was using a Right-wing political platform as the springboard for making some suitably Right-leaning and somewhat mischievous comments about Sino-US relations in various spheres, Bitcoin being an interesting and topical one.
Having stated, entirely uncontroversially, that the CCP does not like the power that the US Dollar, as the world’s reserve currency, confers upon the US, Thiel went on to state that Bitcoin threatens traditional fiat currencies like the US Dollar. We have argued in this piece that this is not the case – for the moment, at least.
We have also argued here that China, whilst undoubtedly holding significant amounts of Bitcoin, is ideologically opposed to the whole decentralized, self-regulating nature of cryptocurrencies, and that the CCP is therefore unlikely to be plotting world domination by promoting Bitcoin with a view to its overtaking the US Dollar as a new reserve currency. Indeed, any such suggestion is absurd.
So just how could China use Bitcoin as a financial weapon against US interests, as Peter Thiel would have us believe? There is a potential threat stemming not from the value of Bitcoin that the CCP owns, but from China’s dominance of Bitcoin mining and production. It could in principle intervene in harmful ways in the costs of mining and – ultimately – challenge the basic principle of Bitcoins being finite in nature.
To what end? Well, the mindset of the CCP is, has always been, and will remain, a mystery. But it would not be inconceivable that it could try by covert means to derail Bitcoin if for no other reason than to ensure the wholesale uptake by its population of a digitalized yuan.
Maybe Peter Thiel has a point…
MATTHEW FEARGRIEVE is an investment management consultant. You can read his investing blog here and see his Twitter feed here.
Investment management consultant MATTHEW FEARGRIEVE considers the rise in house prices during the COVID-19 pandemic, fuelled by the stamp duty holiday, and asks whether the UK economy can possibly support the property market when the tax breaks run out later this year.
The estate agent hype is as shameless as the price rises are astounding. Property prices are up considerably on 2020 and 2019 figures, and agents are reporting the busiest first calendar quarter in years, with a 50 per cent increase in transactions in February compared to the same time last year. Fuelled by the stamp duty holiday, which offers buyers tax savings of up to £15,000, house prices have risen steadily, month on month, since chancellor Rishi Sunak introduced the tax holiday in the spring of 2020.
Despite a drop of 0.2% in March, brought about by anticipation of the end of the stamp duty holiday planned for 31 March, prices are now (Spring 2021) some 6 per cent higher than this time last year. With the warmer months of spring traditionally marking the start of the property buying season, and the news in late March that the buyer tax holiday will be extended until 30 June, the demand for homes and the attendant price buoyancy is expected to last at least until then.
Hence the uncontrolled estate agent hype surrounding the market right now. With buyer demand reaching mania in some parts of the UK, with wealthy top-of-the-ladder homeowners buying favours from agents by offering a “buyer premium” of undisclosed amounts (on top of the purchase price, that is), bidding wars pushing up purchase prices considerably in excess of asking prices and housing demand outstripping supply, estate agents are cock-a-hoop.
One of the UK’s leading online property markets, Rightmove, sent subscribers like me an email prior to the Easter holiday, informing them of an unprecedented “rush to Rightmove” as the website registered more clicks in one day than ever before. There followed a (slightly patronising) explanation of why people traditionally use the long Easter weekend to get out and look at property (apparently), after having been cooped up all winter (presumably having nothing better to do with themselves at the start of springtime).
Adding fuel to the property inferno is the government’s Help to Buy scheme, which enables those first-time buyers able to stump up 5 per cent of the deposit to borrow between 20 and 40 per cent of the purchase price from the government. (We have commented previously on the dangers for first time buyers that lurk within this scheme, which you can read about here.)
The hype from all parties with a commercial interest in the UK property market – agents, sellers, brokers, mortgage lenders, etc – is unrelenting and shameless. And so you would be forgiven for getting carried away by the hype and for joining the “rush to Rightmove”.
To buy now would undoubtedly be to buy in a rising market. To have an offer accepted now would, in some parts of the UK, leave you with a doubtful chance of completing the purchase transaction prior to the end of the stamp duty holiday, currently scheduled for the end of June.
In short, to involve yourself at all with the UK property market at any time between now and the end of June (assuming no further extension of the stamp duty relief, that is) would be to embroil yourself in an inflated bubble market, that can only end one way when the government props are pulled out from underneath. Right?
When we last wrote about the state of the UK housing market, in our blog What Next for UK House Prices, it was to comment on the likely effect on house prices of the stamp duty holiday being extended for an additional three months, from end-March to end-June. Estate agent hype was already rife, and we examined some of the bare-faced assertions being made by property professionals and other interested parties about why it was the Right time to Buy. We discussed how, on the contrary, the fundamental underlying economic essentials and other factors meant that quite the opposite was true. We urged would-be buyers to look beyond the hype and to consider some basic facts of life before joining the rush. You can read more about this by clicking here.
Since we wrote that article in March, two things have changed. First, unemployment forecasts have been updated. Secondly, data about the housing market in London have been released. Both sets of data have a profound bearing on the direction and prospects of the UK property market.
UK unemployment forecasts
Over the three months to January, unemployment in the UK fell from 5.1% to 5%. Much was made of this encouraging headline. But the backdrop to this is that unemployment is expected to rise to 6.5% by the end 2021, once the government’s furlough support schemes – seen by many to be artificially propping up employment levels, just as the stamp duty holiday may be seen to be propping up the property market – are brought to an end. The government spending of billions of tax pounds simply cannot go on indefinitely. As chancellor Sunak has repeatedly pointed out, all this money has to be paid by somehow, sometime, by the UK taxpayer. The withdrawal of both schemes – furlough and stamp duty relief – will inevitably have a dampening effect on buyer demand and families’ appetite to move home, as the reality of a world without furlough and juicy tax breaks finally kicks in.
So, a drop-off in house sales should be expected after 30 June – assuming the stamp duty holiday is not extended further, and there is a broad consensus that the government will not – indeed, cannot – extend it further.
But how bad will that drop-off be? Will it be more than a normalization of property valuations, something more like a crash?
It is difficult, on any rational outlook, to conceive of house prices being self-sustaining at current levels after the government kicks away the crutches of stamp duty relief and furlough pay. Just think about the economic fundamentals at play. During the biggest economic slump in modern history, when nine million people were sitting idle at home, their wages paid by the taxpayer, we have had a miracle property boom in which prices have risen 6 per cent. Something isn’t right. Something has got to give.
As ever, London drives the rest of the country’s economy. This has always been true in the housing market, and the (overstated) exodus of workers from the capital doesn’t make this any less true. A market crunch in London likely results in a crunch across the rest of the UK.
London is particularly vulnerable to a depression in its residential property market because the price of houses in the city, as opposed to flats, rose particularly sharply over 2020, while the population of the capital is estimated to have fallen sharply as foreign workers appear to have left in the pandemic. With the vast majority of the capital’s population living in flats, and a number of these currently tenantless, the surge in the price of its much smaller stock of houses last year will have to be corrected.
A recent report by the London School of Economics opines that there is a “significant risk of [government] policy trying to prop up house price growth [….] together with the fact that the stamp duty holiday disproportionately boosted more expensive houses and housing markets, we would expect the [….] situation of a housing market downturn”. This downturn would, in the view of the LSE, be accelerated by an economic downturn.
Given that the pandemic has brought about the deepest recession in the UK for three hundred years, some economic downturn seems highly likely. You don’t have to be an economist to think that. In such circumstances, could the miraculous hikes in house prices possibly be sustained? The LSE’s report goes on to state that, even if the stamp duty and/or furlough schemes were extended (which the LSE considers highly unlikely), the visible effects of the coming economic downturn would merely be deferred.
The support, the props offered by the government – furlough and property tax breaks- are sticking-plasters. They do not, cannot, heal the economic wound that has been, and will be, inflicted by the lockdown of our national economy during the pandemic.
What Next for the UK Property Market?
There are those who, with some justification, believe that no UK government will ever allow the property market to collapse, that government intervention is guaranteed when the market starts to drop. After all, the country’s retail banking sector depends on people borrowing mortgages, and being able to repay them. Buying property has become, in the UK (perhaps uniquely in the world) a one-way bet, and a safe(ish) one.
That may be true. What is far harder to accept is the blind, unrelenting hype, and the assertion that UK house prices are sustainable at current levels. The miraculous gains of 2020 will be subject to an inevitable correction as post-pandemic economic reality sinks in. The harsher that economic reality, the more severe the correction; the harder the property hubris and the property euphoria – which must be unique to the British more than any other people in the world – will be punished.
MATTHEW FEARGRIEVE is an investment management consultant. You can read his personal finance blog here and see his Twitter feed here. You can read his property blog here.
The UK government unveiled its Help to Buy scheme for first time buyers in March: so is it all good news for those wishing to get a foot on the property ladder, or are there dangers lurking within? Investment management consultant MATTHEW FEARGRIEVE explains why would-be homeowners need to be careful.
The Help to Buy equity loan scheme is available to first time buyers who have a deposit of 5% to put down.
Rather than taking out a mortgage for the remaining 95% of the property value, the Government lends you 20% of the property price, and so you only need a mortgage for the remaining 75%.
If you’re buying a property in pricey London, the Government will lend you up to 40% of the property price. Once your 5% deposit is factored in, that means you will need a mortgage for 55% of the property value.
Government equity loan is interest-free for the first five years. After that, you pay a monthly interest fee of 1.75% of the equity loan. The interest rate will rise each year in April by the Consumer Price Index (CPI) measure of inflation, plus 2%.
The loan can only be used to buy your main home, and not a Buy to Let property.
These rules only apply to properties in England. Wales, Scotland and Northern Ireland have similar schemes.
So, first-time buyers, it all sounds great, doesn’t it? Well, not quite. Beware of the dangers lurking underneath the glossy veneer of the scheme. Here is a summary of the downsides and pitfalls you need to be aware of.
First and Foremost: this is a government scheme. This means that there are economic and political considerations at play being the scenes. Governments are keen to win votes and popular schemes like this one, just like the furlough schemes (and remember the Eat Out scheme back in the summer last year?), are inevitably designed to be vote-winners.
They are also designed, like the stamp duty holiday, to prop up the UK property market.
This doesn’t mean that the scheme is right for you. You need to make sure that you, personally, after carefully considering your own financial and employment situation, can afford to borrow large amounts of money that you might not in future be able to repay (and don’t forget the interest charged in addition).
Remember, the “Help” is a still a Debt. The money the government lends you will have to be repaid. And, just like any lending on property, if you can’t keep up with the repayments, you may lose your home. True, the government is lending you one-fifth of the purchase price (two-fifths if you are buying in London). You are stumping up at least 5% of your own money.
Most of the purchase price (55% to 75%) still needs to come from someone or somewhere, and for 99.9% of first time buyers, these means a commercial lender: a bank or building society will lend you that money, in the form of a mortgage.
That mortgage – just like the government loan – will need to be repaid.
Remember, home “ownership” is an illusion for the vast majority of first time buyers (and, indeed for most other homebuyers), because the lender will own most of your home until it has been repaid. So, whilst shipping out of your parents’ home, or moving out of rental accommodation, may seem attractive, you should guard against fooling yourself into believing that you are transitioning to “home ownership”. For most users of the government’s scheme, they will own 5% of their home, and not more. The other 95% will be owned by the lenders, who can evict you if you can’t pay them.
Sounds a bit like renting, doesn’t it? Only the financial and emotional cost to you will be far, far greater than renting. Don’t be in a hurry to turn your back on renting.
Can you truly afford the lending? Having understood that you will not truly “own” the property that you are acquiring, the next psychological adjustment to make is an important one. Don’t ask yourself if you can afford to buy. Instead, ask yourself if you can afford the repayment terms of the borrowing you are taking on.
Is this really the time to borrow? At the end of the day, and maybe in return for just 5% of the property, you will be taking on a large mortgage debt (and maybe using up your savings to stump up the 5%) at a time of unprecedented economic problems (present and pending) when (a) the terms of mortgage lending and (b) job and income security, are at their most unstable. You might find you needed the savings you have sunk into the deposit, just to meet your living costs. You might find, as furlough schemes end and employers start to get back to “normal” this summer/autumn (again, who knows), that your job/income is not as secure as you thought. Even if it is, your mortgage lender’s opinion of your attractiveness as a debtor may change, and you could find yourself with lending withdrawn or with significantly higher monthly repayments.
Don’t let the Scheme be the only reason for wanting to buy. Sure, 20% is a very helpful chunk of the money you need to secure a property to make your home. But the government scheme shouldn’t be the only, or main, reason why you want, at this moment in time, to buy a home.
You should want to buy because you believe that the time is truly right for you to transition out of Mum and Dad’s place, or rental accommodation, and into the serious business of paying a mortgage (and the government; two lenders). You should have done all your homework and financial planning, all the maths and the calculations, taken into all the risks (unemployment, recession, illness etc) and have concluded that you can really can afford to repay the money you are going to be borrowing.
What about Property Prices? So, you’ve put to one side the government scheme, and you have worked out (after doing your homework) that you can afford the borrowing that you want to take on. The next thing to consider is property prices. Is now a good time to enter the UK property market?
This is where we can’t help you. No one has the crystal ball that will enable us to see what direction property prices will take over the coming months. But we can give you some pointers that you might like to keep in mind as you wonder whether that property is really worth the asking price, and all that money you are going to have to borrow….
Yes, you would be buying in a high market if you were to complete a purchase right now. If you had an offer agreed now, it is questionable whether it would complete before the end of the stamp duty holiday on 30 June. If it completed, say, on 1 July, you would have additional stamp duty to pay. (So don’t let the stamp duty holiday be the main thing driving you to buy, either).
I might be more sensible to keep an eye on the market, but took a cooler approach and wait to see what happens to prices post-30 June. As “normality” and economic issues creep in, you might find a decrease in prices in the autumn and in 2022. This is our personal forecast, shared by some and not shared by others. Who knows.
Don’t, though, expect a massive drop in prices this year or next. We believe that the property market, like the stock market, is sustained a lot by hope, emotion and – most of all- greed (in other words, short-term profit taking by all players – banks, estate agents, sellers). These factors, whilst disagreeable, do motor the property market, just like they motor the stock market.
You might like to keep an eye on inflation forecasts. In an inflationary price scenario, the value of your Pound goes down. Infrastructure and construction, like everything else, becomes more expensive, and this cost is passed on to house buyers, in the form of higher prices. Opinion right now is very divided about whether inflation will come into play this year or next – if at all. Don’t stress about inflation too much, but keep it in mind when you are thinking about possible future price movements.
On the other hand, don’t worry about prices going down after you have bought. Looking back at the UK property market over the last three decades, we believe that it will increase in value over time, with a few “blips” in between. Consider the high level of buying that has gone on during the stamp duty holiday. Most of this activity has been motored by people who, having bought twelve, fifteen, twenty or more years ago, find themselves “property rich” – the value of their home(s) has increased so much, relative to the purchase price, that they feel empowered to borrow on the value of their homes and buy some more. The UK property market has been, on the whole and in many parts of the UK, a good long-term investment.
Be wary of the advice of older homeowners. Particularly mum and dad, or other family members, who offer you positive encouragement to “get your foot on the ladder”. Committing to the lending that a property purchase entails has to make financial sense for you. If it doesn’t make sense, it doesn’t make sense. That doesn’t mean that it won’t make sense for you at some future time.
And remember, times were very different when older homeowners bought their first home. Their advice needs to be evaluated, not blindly accepted as the wisdom of older, more experienced people.
Have we put you off trying to buy your first home, yet?! Well, we did not set out to try to do that. This article is designed to encourage you to think twice before taking the leap into home ownership (with our without the government’s Help to Buy scheme).
We leave you with these final thoughts, as we wish you luck on your journey:
1. Make sure that you can afford any repayments entailed by any government scheme in the event that they accelerate the repayment schedule, or demand repayment. You never know what the government may be forced to do, post-pandemic (always assuming that we are actually coming out of it, which is not yet certain).
2. Make sure you can afford – truly afford – any purchase monies you borrow from a commercial lender (bank, building society). Ask yourself whether you could afford to pay more per month in the event that they accelerate the payment schedule or – worse – withdraw the lending deal you signed up to if your circumstances change (or their opinion of your personal circumstances changes).
3. Do not rush to buy just because of the availability of the government scheme. Five per cent, whilst helpful, is not a huge help! If you can’t truly afford the other 95%, then you rent.
4. If the lending you need to take on is affordable, even if the lender changes the repayment and/or interest terms, or later withdraws or significantly modifies what you signed up for, then don’t worry about blips in the property market value. Having a stake in your own home is always better than paying someone rent.
5. Think twice before turning your back on renting. It is a tenant’s market right now, in many parts of the country, and there are deals to be done with landlords on rent.
6. Consider your job prospects over the next three years. Is your income as secure and sustainable as you think it is?
7. Think about your age. We receive anxious emails from people in their early twenties, some of whom have barely left their parents’ home, or are still in it. Don’t obsess about home “ownership” when you should be having fun (without overspending!). Someone in their twenties (and, we would say, thirties) has plenty of time to save money with a view to getting onto the property ladder.
8. When comparing renting to buying, always remember that for most first-time buyers, home “ownership” is an illusion. If you need a mortgage, the bank will own most of your home, and will do, in most people’s cases, for years. This brings you back to carefully considering, as unemotionally as possible, whether you can really afford that mortgage on the terms offered. Mortgage lending can be liberating. It can also make your life a misery if you can’t keep up with the repayment demands.
9. Try to remain unemotional. We all fall in love with a property. But don’t let love blind you. And don’t let love (or your ego) lead you to buy something bigger and/or more expensive than what you really need/can afford.
10. Beware the advice of older family members and/or homeowners egging you on to “buy” and “get your foot on the property ladder”. The step has to make financial sense for you. If it doesn’t – then you carry on living at home or in rental accommodation. Bide your time.
MATTHEW FEARGRIEVE is an investment management consultant. You can read his property blog here and his Twitter feed here.
IMPORTANT: the views stated in this article are the author’s opinion only, and are not intended to be relied on as advice, for which you should rely on your own professional advisers.
Investment management consultant MATTHEW FEARGRIEVE explains why yields on government bonds are rising, and why they are set to continue to rise.
No surprises at this week’s meeting of the Federal Open Market Committee (FOMC). The Fed is committed to doing – or, at least, committed to being seen to be doing – everything it takes to support the post-pandemic US economic recovery.
So interest rates are to remain on the floor until at least 2023; and fiscal stimulus (on a massive scale) has been accounted for, factored in, allowances made.
So goes the (intentionally) comforting rhetoric of the Fed. The hike in the Fed’s inflation rate for 2021 will not have gone unnoticed, however. Inflation fears have been spooking the markets for weeks already, and now the Fed has revised its forecast upwards, from 1.8% to 2.4%.
The other big take-away from the FOMC meeting was the Fed’s continuing commitment to purchasing a minimum of US$120 billion of US Treasury bonds and mortgage-backed securities every month.
The yield on US 10-year Treasuries fell on this news. From a level of around 0.9% in December 2020, the 10-year US Treasury yield had risen throughout February to around 1.6%. (This yield is about 2.3% higher than the yield on 10-year Treasury Inflation-Protected Securities, or “TIPS”, compared with a gap of just under 2.0% at the end of last year.) The low rate of December was a sure indication that the markets considered the risk of inflationary erosion on a ten-year debt to be minimal.
So it seems that inflation, if not de facto with us already, may be just around the corner.
The question is when yields on 10-year treasuries will normalise to pre-crisis levels indicated by TIPS (around 2% nominal and 0% real); whether this will happen this year or not. So far this year, nominal yields are up 60bp to 1.54% and real yields are up 40bp to -0.66%. And after the Fed meeting this week, we need to factor in inflation expectations up 22bp to 2.4%.
But as far as yields on government bonds are concerned, the markets have been pricing in inflation for some time. Government stimulus packages and the release of deferred consumer spending post-lockdown are largely at the root of this, and markets have been further spooked by bond vigilantes selling bonds in large amounts, thereby increasing yields.
This, then, is the backdrop to the Fed (and, across the Pond, the European Central Bank) committing to buying more government bonds. An effort to curtail further rises in yields and to avoid, at all costs, a repeat of the 2013 ‘Taper Tantrum’, when the Fed’s decision to reduce its Treasury bond purchasing panicked investors and pushed yields higher.
So: will the Fed’s action be sufficient to reign in the recent rise in yields?
We think not (and we hope we are wrong). We don’t know the detail of the thinking behind the Fed’s decisions, of course, but it could be that their Top Brass considers any whiff of inflation in the air to be purely transitory, an inevitable component of the alluring perfume of economic recovery post-pandemic.
This would be a rational thing to believe: think of the massive (and, the Fed says, necessary) stimulus spending and the hundreds of millions of frustrated consumers soon to hit the malls again – naturally, these circumstances seem set fair to usher in a period of price inflation.
The Fed – we may assume – is banking on any inflationary phase being purely transitory. But what if it is not? What if the inflationary pressure are more persistent and longer-lived?
The vaccine rollout has been a huge boost to the US growth prospects, the US labour market is tightening back up relatively quickly (remember, the Fed has admitted that the jobless rate has become a less reliable inflation signal), supply constraints are still prevalent and there is negligible deleveraging pressure anywhere in US policy or in the US economy.
So the Fed is running the economy “hot”. And whilst it would be rash to think that it will let inflation carry us all away (think of the generous fiscal and monetary policies which in the 60s caused consumer price inflation to leap from under 2% to 5% in the space of a decade) investors should not lose sight of the fact that the mind of the Fed is like the mind of God: unknowable.
So we must remain ignorant of the extent of the Fed’s tolerance of persistent inflationary pressures before it will feel compelled to take normalising action. For the moment, all we have to go on is low interest rates and a verbal commitment to repurchasing US Treasuries.
And we are also ignorant, for the moment, of the longer-term impact of the Fed’s decision this week on bond yields. Before the FOMC meeting, yields on one-to- three year TIPS were depressed in line with rising expectations of inflation and the prospect of Biden’s US$1.9 trillion stimulus package. Simultaneously, medium- and long- term yields were rising.
We think these trends will continue, notwithstanding bond-buying by the Fed (or, for that matter, the ECB in Europe). We know now, after the Fed announcements this week, that:
growth and inflation expectations have been upgraded;
the US government is set to issue more debt; and
the Fed (and, therefore, the Eurozone) is still de facto committed to its 2% inflation limit, notwithstanding the rise in its 2021 inflation forecast to an upper limit of 2.4%.
These dynamics do not dispel the looming prospect of inflation. Nor do they comprehensively discourage the bond vigilantes. We think the markets will continue to fret about a coming inflationary environment. Yields on government bonds have further to climb.
We hope you found this article and the opinions therein informative. To learn more about bonds and bond yields, click here. To learn about the impact of inflation on your personal investments, click here.
IMPORTANT: the views expressed in this article are opinion only, and are not intended to be relied upon as financial advice or treated as a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.
Investment management consultant MATTHEW FEARGRIEVE explains the impact the current rise in government bond yields will have on the equities and bonds in your investment portfolio.
At its meeting on 17 March, the Federal Open Market Committee (FOMC) confirmed that interest rates in the US would remain at zero. There was no surprise here; it was widely anticipated that the Fed would remain committed to its policy of supporting the US economy until it is back on its feet. As if to underscore this, the Fed indicated that it isn’t expecting a rate increase until 2023 at the earliest, and reiterated that the bar for raising the rate will remain high.
Whilst intimating that its inflation expectations remain anchored, the Fed nonetheless scaled up its inflation forecast for 2021, which it now sees as running to 2.4%, ahead of its previous estimate of 1.8%.
The Fed also remained committed to the pace it has set for bond buying. It will continue purchasing at least US$120 billion of US Treasury bonds and mortgage-backed securities each month. The yield on the 10-year Treasury note fell on this news.
So: low interest rates, rising inflation forecasts and government bond repurchases, on top of huge, post-pandemic government spending programmes: this is the (entirely natural) backdrop to the recent inexorable rise in yields on government bonds.
Why are yields on government bonds rising?
Yields on government-issued debt instruments are rising because of two things inflation and fiscal stimulus. These two dynamics normally cause price inflation.
Inflation is bad for government bonds. When prices rise at a rate greater than the interest earned on a bond, it follows that the value of the fixed income delivered by the bond will fall. Consider a five-year bond paying 2% nominal interest. If inflation rises to 2.5% for those five years, the income paid by the bond will not be able to keep up.
Fiscal stimulus is also bad for government bonds. When governments pump out debt, the price of bonds falls, whereas the yield, being inversely related to bond prices, rises. A related market phenomenon is the recent emergence of bond vigilantes, bond investors who discourage fiscal stimulus by selling bonds in large amounts, thereby increasing bond yields. This in turn makes borrowing more expensive for governments, which acts as a potential disincentive on issuing more debt, which is the desired goal of the vigilantes.
Rising yields in turn depress bond prices, making investment in bonds and government debt less attractive. The combined market forces of inflation and rising yields have caused the market value of bonds to fall, as have the activities of the bond vigilantes.
The rising yields will stick around for as long as inflation is a worry. And an inflationary economic environment favours certain kinds of asset classes.
What do rising bond yields mean for my portfolio?
When thinking about rising bond yields and the prospect of inflation, it is necessary as usual to consider separately the “bonds” (debt) and the “equities” (stocks and shares) components of your portfolio.
Given the uncertainties in the bond markets, you would be forgiven for thinking about moving some of your bond and fixed-income investments into cash, whilst waiting to see where longer-term bond rates end up.
Whilst uncertainties in the bond (and equity) markets might argue in favour of increasing your cash reserve to between 10% to 17% of the overall value of your portfolio, you can are by no means precluded from buying bond funds for your portfolio. Just make sure that you follow these two, protective rules.
First, avoid bonds with longer maturities, say, anything over three to five years. Bonds with longer maturities are more exposed to changes in interest rates, meaning they have more to lose if rates rise (which they invariably do, once inflation kicks in).
Secondly: use inflation-linked bonds (like TIPS) as a way of keeping your money in fixed income whilst protecting against inflation risks. The coupon offered on these bonds is linked to a rate of inflation, meaning the interest they pay rises as inflation goes up.
What follows are some low cost, exchange traded funds (ETFs) and mutual funds that provide (a) index-linked exposure to government debt and (b) equities in the asset classes just discussed, both in return for an acceptably-low annual charge.
Please remember, these are ideas only, not recommendations or formal investment advice.
The iShares USD TIPS 0-5 UCITS ETF (GBP Hedged) combines both protections, by investing in index-linked US Treasury Bonds with short maturities (0-5 years). With a respectable performance history, a low buy price (around £5 per unit at time of writing) and an annual charge of 0.12%, this product allows you to include bonds in your portfolio and hedge against possible losses due to inflation.
A suitable bedfellow for this fund could be the Lyxor Core UK Government Inflation Linked Bond UCITS ETF, providing access to UK government bonds with in-built protection against inflation, for an OCF of just 0.07% (upside) and a rather high per-unit buy price of around £20 (downside).
Market fears about inflation are already being played out on the US Nasdaq index, which is dominated by high growth tech stocks. The index has fallen by more than 8% in the past two weeks.
Inflation, though, is not necessarily a bad thing for all stocks. Indeed, it has different implications for different types equities. A big consequence of inflation (or the fear thereof) is to drive in the realm of investor sentiment a rotation out of (high-value) growth stocks into (cheaper and more cyclical) value stocks.
Growth stocks were the big winners of 2020: the tech, pharma and stay-at-home retail stocks, which did so well partly because of the low rate, low inflation environment. An inflationary environment threatens that appeal.
And so US mutual funds focused on value stocks enjoyed inflows of US$6.3bn in February, up from US$1.3bn in January. Growth funds, in contrast, saw outflows of US$18bn in January.
Correspondingly, the MSCI global value index has risen nearly 9% so far this year. In 2020r it fell by 3.6%, lagging the MSCI global growth index by 33% as money poured into stocks like Tesla, Peloton and Apple. So far in 2021, in contrast, it is the likes of ExxonMobil, Caterpillar and Wells Fargo that are doing better.
Gold, property, commodities, infrastructure and smaller companies are sectors that are set to do better than they did over the pandemic. The kinds of stocks which have benefited so much from the a low-rate, low-inflation environment that we have had for some time – the prime example being Big Tech- are now expected to perform less well than they did in 2020.
Sectors like materials, commodities, consumer goods and industrials are all expected to start to do better as global economies start to pick up speed.
Commodities historically outperform when inflation kicks in. Their relationship is not clear cut though. Rising commodity prices tend to be both a cause and a reflection of inflation. Commodity producers often raise their prices in line with inflation because their cost of production goes up, in turn exacerbating those rises.
Separately, asset classes like property and infrastructure often do well in times of inflation. Infrastructure assets have explicit linkage to inflation, and the relationship of infrastructure to property is instructive: as prices rise, so do building costs, and therefore, so do property prices.
Lastly, many investors will have their eye on gold. Many of us will have bought some exposure to gold miners and gold producers for our portfolios at the start of the pandemic, given that gold is the traditional flight-to-safety asset when equity markets are turbulent. When inflation is driven by rising commodity prices, gold tends to do well.
The Lazard Commodities fund tracks the Bloomberg Commodity Total Return Index, with most of its exposure to blue chip gold, gas and agricultural producers and processers in the US and the UK. The fund is structured as a Dublin OEIC and this entails higher fees: an annual charge of 0.50% together with a per-transaction cost of 0.48%, which will be a turn-off for some investors.
A cheaper alternative to give your portfolio indirect exposure to international property, and with respectable five year performance, is BlackRock’s iShares Global Property Securities Equity Index Fund, rated with three Stars by Morningstar and priced at an attractive 0.18% per year with an additional 0.08% per-transaction fee. The fund is an ETF that tracks the FTSE EPRA Nareit Custom Developed Index, which provides you with proxy access to global property companies, just over the majority of which are in the US, with the remainder being fairly evenly split across Canada, Europe (including the UK), MENA, Asia Pacific (including Japan) and Australia.
We explored the fortunes of gold prices over 2020, and their unlikely “safe haven” pairing with Bitcoin in our earlier blog here.
Ninety One Global Gold 1 Acc is a globally invested OEIC owning shares of companies involved in gold mining and in related derivatives, is another holding, and is up 37% over 12 months.
A well-performing catch-all for gold and precious metals with Golden Prospect Precious Metals, which has an underlying investment split of 66% gold, and 25% silver, where producers are 64% and developers 24%.
A higher-costing but still decent alternative with reasonable performance is the WisdomTree Physical Gold ETF, which has an annual charge of 0.39%.
Opinion is divided on the attractiveness of emerging markets. A more positive view is that emerging market economies are a good indirect bet as they benefit from the positive pulse of increased spending by the US consumer.
An alternative providing broad indirect access to emerging markets is the Artemis Global Emerging Markets fund. Like the Stewart fund, this has the majority of its exposure to the Emerging Asia zone, but has additionally positions in Africa, Latin America and Emerging Europe.
For investors cautious about the prospects for recovery and for rising inflation, and wanting the convenience of a blended fund, the AJ Bell Personal Assets Trust offers a suitably cautious approach with some inbuilt inflation-proofing: it layers a 12% exposure to gold and a 35% allocation to index-linked bonds over a core 40% exposure to high-quality equities like Microsoft, Diageo and Unilever.
The convenience of having a one-stop-shop fund like this comes at a price however: a relatively stiff OCF of 0.86% per annum, but still not bad for coming in at under 1.00% per year.
To learn more about bonds and bond yields, click here.
To find out more about mutual funds and ETFs that could protect your portfolio from inflation, click here
For some Ideas for yourISA in a post-pandemic recovery phase (reflationary or inflationary) click here for our earlier blog on how to make the most of your 2020/21 tax allowances before the end of the tax year on 5 April.
For our 2021 Investment Outlook across all the major asset classes, click here.
MATTHEW FEARGRIEVE is an investment management consultant. You can read his investing blog here and see his Twitter feed here.
IMPORTANT: the views expressed in this article are opinion only, and are not intended to be relied upon as financial advice or treated as a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.