What happened to the 'great rotation'?

FT.com

Are we ready to rotate yet? A year ago, there was talk of a “great rotation” from bonds to stocks. Since then, the US Federal Reserve has tested the water, telling the market it was ready to “taper” its Treasury bond purchases.

That revealed an appetite to switch out of bonds as their prices fell sharply, causing yields — which set the interest rates used for transactions throughout the world — to rise. They rose fast enough to persuade the Fed that it should wait before starting to taper off its purchases.

Bond prices have risen for three decades. It makes complete sense for this cycle to change. But which investors will rotate out of bonds and with what consequences?

Let us start with big fund managers. They have the most direct effect on prices day to day and they seem to be rotating. The latest survey by Bank of America Merrill Lynch, covering 172 managers running $US518 billion, found the greatest “underweight” position in bonds — relative to their benchmark — since April 2006.

But there is no great rotation into stocks. Instead, they have 4.6 per cent in cash, in which a growing number are overweight; 80 per cent expect the world economy to grow below its trend over the next 12 months.

US retail investors are also important. They almost single-handedly drove the dotcom bubble of the late 1990s. But their behaviour after two stockmarket crashes is different.

Avi Nachmany, of the research group Strategic Insight in New York, suggests that asset allocation is about the psychological need for safety and reassurance after the crises.

In 2007, pre-crisis, bond funds made up 23 per cent of sales of long-term funds in the US. Last year, that figure was 40 per cent. This year, it is 39 per cent.

Nachmany suggests that two rotations are at work. One is from being totally uninvested to putting money into risky assets; the other is from cash to equity income and bond funds, which give the best guarantee of avoiding a big loss.

Further, most mutual funds in the US are sold through asset allocation programs that involve automatic switches between bonds and stocks, so automatic stabilisers are in place to damp any “great rotation”.

Then come pension funds. Their attitude to bonds is complicated. Bond yields set the rate at which future liabilities to their pensioners are discounted. The higher the yield now, the lower the future liabilities. (Put differently, if you need to guarantee to pay a certain sum in the future, the way to do this is through bonds that make a guaranteed payout. The higher the interest rate, the fewer bonds you need to buy to meet that guarantee.)

Low bond yields caused a sharp increase in their deficits — the extent to which their assets lagged their liabilities. The summer “taper talk” rise in yields has already helped them out. Deficits have reduced. But here the perversities start. Actuaries say their reaction to deliverance from a deficit (driven by falling bond prices) may well be to “de-risk” and buy bonds.

Now we come to the most important investors: foreign governments and central banks. In the years before the last crisis, the Fed, under Alan Greenspan, had the opposite problem to the one that faces Ben Bernanke’s Fed today. He raised short-term rates but failed to push up long-term bond yields. Mr Greenspan called this a “conundrum”. A popular explanation was to blame buying by foreign governments, led by China.

Their economies were growing fast, making huge profits from exports and building up foreign exchange reserves. These were largely held in Treasury bonds. As China and others bought Treasuries, they pushed yields downwards, counteracting the Fed.

In the “conundrum” era, from 2002 to 2005, foreign holdings of Treasuries doubled from $US1 trillion to $US2 trillion. They went on to top $US5.7 trillion. In the last few months, they have tapered off, from $US5.72 trillion in March to $US5.59 trillion four months later.

How to explain this? Reserve accumulation has been dwindling for a while as emerging market growth has slowed. Or they may have acted like fund managers, listened to the Fed’s threats to end stimulus and tapered their bond holdings.

The natural consequence would be to raise Treasury yields - which happened this summer. If the trend continues, it would push bond yields up and limit the Fed’s ability to keep them low while weakening the dollar.

So far, however, what has happened is barely even a “taper,” let alone a “great rotation”. Despite some paranoid US commentary, it is not in the holders’ interests to sell them all in a hurry. That would create a self-inflicted loss.

A big move into equities would delight many while a sudden move out of bonds is one of the greatest nightmares out there. Both could happen. The checks and balances of the world’s investment system should slow down either outcome. But any attempt to rotate must be watched very carefully.

Copyright The Financial Times Limited 2013