John Jeffery
John Jeffery

Deteriorating global economic conditions have been extremely supportive of the global government debt markets. The inverse relationship between yields and prices (effectively falling interest rates cause bond prices to rise) has produced a very rewarding environment for bond bulls with an unprecedented bond market rally, none more so than in the United Kingdom Gilt market. The Long Gilt bond prices are shown in the chart below. Gilts, so named because the bond certificates used to be presented on gilt edged paper, are the way the UK government finances any sort of debt and the term ‘long’ refers to debt that is not set to be repaid for at least 15 years. The question of the ability for this market to continue extending gains needs to be addressed as it has a relative value impact on the equity markets. At what stage do these ‘high quality / flight to quality type assets’ no longer represent value and when will investor’s money seek better yields and returns from the equity market?

Although economic weakness and the near-term absence of inflation (some would argue deflation resulting from the global commodity and energy price collapse) are supportive factors for the fixed income asset class in the short term, I would argue that these factors are already priced in to the current low yields. Ostensibly, we are approaching a top of some description. The RSI and price resistance lines would also allude to this point from a technical perspective, as would the 5, 35 day oscillator (not shown).

The extended Bull Run leading up to the highs of around 125 in December shows a clear retracement to the 116 level. Although this forms part of an Elliott Wave 4 pull back, the oscillator shows such a deep decline that it cannot be considered a potential EW4 trade. The most likely scenario is a sideways market until support is broken.

click chart for more detail
click to enlarge

Liquidity and risk aversion have been the main bond market drivers over the past six months, but there is a major disruption to this existing status quo that is not yet definitively in the open. In fact, the total numbers involved is not yet even known by those responsible for setting them! This disruption is, of course, from the potentially huge increase in supply of government bonds. Again, although we are specifically talking about the UK and Gilt market in this article, it is worth noting that this will be a global phenomenon. Governments around the western world need to raise capital to combat budget deficits resulting from lower tax returns and an increase in benefit expenditure – a direct result of increased unemployment and declines in tax receipts from business. In Australia, the lucrative taxes on mineral exports and property will also be lost to recessionary pressures.

The supply does not end there, either. If you then compound the billions (trillions?) required to finance various rescue packages, it is evident that this increased supply is likely to be a major theme for 2009 and beyond. As with any asset, an increase in supply will no doubt have an impact on the relative price and therefore yield of this AAA rated paper. Equities (in particular quality Blue Chips) will soon begin to look increasingly attractive as alternatives. The next equity boom will not be resources or technology driven, it will be quality driven.

Stay Sharp,

John Jeffery