I'm speaking of a time…

The oldest among us – those who remember the oil shocks of the 1970s and 10-year French rates of more than 15% – look on with amusement at the open debates by the European Central Bank on the prospect of offering banks a negative yield on their short-term deposits.

The time when long and short-term rate yields were attractive is nevertheless not all that long ago and the young fifty-year olds who began to invest during the 1980s, also witnessed double-digit interest rates.

The time when long and short-term rate yields were attractive is nevertheless not all that long ago and the young fifty-years old who began to invest during the 1980s, also witnessed double-digit interest rates.

Let us remember that in the 1980s, European long-term rates were still close to 10% affected by the memory of unbridled inflation during the 1970s. Then came the terrible month of October 1987: share prices plummeted, rates increased and rose swiftly above the double-digit mark to end at 13% in France. However, the acceleration in the share-price nosedive on 19 October (with the Dow Jones plunging 22% in one day) prompted a new trend involving massive bond purchases and the “flight to quality” was born!

A then star analyst at Morgan Stanley, Stephen Roach, wrote a still-famous note in which he affirmed to readers that in their lifetime, never again would they see double-digit interest rates. His clients at the time, caught up in the torment and fed by 20 years of inflation, found the oracle particularly reckless. Some 26 years later, the courageous forecast made by this visionary analyst has proved to be extremely relevant: with US long-term rates at 2.5% and German rates at 1.5%, the markets have probably even exceeded all his hopes.

Would Mr Roach then say today that the all time low levels recently observed (1.2% for the German Bund and 1.6% for the US rate) will remain engraved as record lows or historical curiosities? This is not so easy to confirm in view of Japan, which has lived with rates at between 0.4% and 2% for more than 20 years.

However, the response to this question is essential for the short-term future of financial markets since, as the old stockmarket saying goes “when you question equities, look at what bonds are doing”.

Used to free money, investors have recently been concerned about the increase in German rates from 1.2% to 1.6%. This brings back bad memories of 1994 when German and French government bonds lost 15% of their value in six months in a sudden plunge that traumatised more than one bond owner. In 1994, the FED began rapidly increasing its short-term rates and implemented six hikes in less than a year! Rest assured, in the year to come at least, we are sheltered from moves of this sort.

While bondholders have been cautious in recent weeks, they are nevertheless massively buying up peripheral European debts, corporate bonds in Spain and Italy: the neglected Europe of recent years has become their favoured investment region. In contrast, they are slightly more demanding concerning the “best” signatures, whether those of the German government or the US state. Today, Germany is borrowing (slightly) more expensively than at end-2012, whereas lending terms in Italy, Spain and Portugal have improved considerably.

In a word, bondholders have been telling us for some time now, that the euro will survive. However, this good news for everyone comes with an additional message via the rising yields on the best pupils: Europe will not only survive, but it will also adapt! Artificially low rates should return to normal and Europe should get out of this deflationary rut…

Let’s accept the bondholders’ prediction and invest in equities!

Didier Le Menestrel
with the king help of Marc Craquelin