Roger Hirst: There's a vast array of different instruments in this category. But for the workshop's purpose today, we'll focus mainly on bonds. And the bond market can seem like a strange place for people who may only have invested in the stock market before. The professional market is dominated by people with mathematics or statistical backgrounds. But fortunately, the reality is less intimidating than it may appear at first.
In essence, bond traders are mainly concerned with pricing just two things-- the level of expected growth and inflation. If correctly anticipated, benchmark government yields will reflect the economic outlook as the so-called risk free rate. In theory, all other debt instruments are priced off the associated risk free rate of that country by adding a risk premium, which is required to compensate investors for the higher risk. So things like checking accounts and mortgages, car loans, corporate loans, and most other debt and credit instruments have interest rates which are tightly linked to the risk free rate for any given maturity or time horizon.
Mortgages, for instance, in the US tend to be in the 20 year space, so they will tend to follow yields of long term treasury bonds plus a premium. Car loans tend to be in the five to seven year space, so they will follow bonds of that maturity. Or as practitioners prefer to call it, the belly of the interest rate curve. Simply put, the further you are away from the central bank's policy rate both in terms of time frame and in terms of the type of product that you're borrowing, the higher the interest rate will be.
The Fed funds or target rates in the US is a rate with commercial banks with which the Fed does business. If you have a short dated liquid instrument borrowed from one of those banks, you should have an interest rate that's not too far from the Fed funds rate. But once you get to credit cards, well, then the interest rates that can be charged are often a million miles away from the Fed's policy rate.
So going back to the key drivers of bonds, we'll break down a couple of the simplest ways to understand growth and inflation expectations, which drive the risk free rates, which then themselves affect the rest of the economy. We discussed the ISM before as an important leading indicator of business activity. But not surprisingly, it also has a clear relationship with future GDP and therefore bond yields. This first chart shows how an increase in the ISM Purchasing Managers' Index tends to lead to an acceleration in GDP growth. This is particularly evident around the major inflection points following the 2008 and 2020 recessions and also the slowdowns in the latter stages of 2012 and 2016.
But a chart of the 10 year bond yield versus GDP won't show as clear as relationship not because the two are unrelated. But rather it's due to the fact that GDP is a lagging indicator. A better comparison is the ISM as we looked at initially. The level and the direction of the ISM provides a good proxy for growth expectations. Hence why the level of bond yields are so in tune with it on a short term basis.
But also recall the chart of truth. Yields in the US have been in a long term downtrend whilst the ISM has consistently oscillated plus or minus a few points around 50, the threshold for expansion and contraction. But this, of course, is just one indicator. And there are many forecasting models which can help us to determine the growth outlook.
One such tool is the Federal Reserve Bank of Atlanta's GDP Now model, which provides one of the most reliable forecasts for US economic growth. Full details about the methodology can be found on the Atlanta Fed's website. But it is essentially constructed by aggregating statistical model forecasts of 13 sub-components that comprise GDP. By tracking these releases in real time, the model is able to provide a running forecast which is far more relevant to the bond market's growth expectations than other lagging indicators.
But just be careful. This is public information and does not provide you with an edge versus anyone else in the market. If anything, you might want to use it as an indicator of where consensus estimates are. It doesn't mean that they're wrong. But every now and then, you might find yourself having a contrarian view on the economy that opens the door to very, very interesting trade ideas.
And other point. Just to throw another spanner in the works, many would argue that the bond market itself is actually the better predictor of growth rather than growth expectations as a decent predictor of bond yields. That's why the yield curve is such an important variable for analyzing business cycles, which we've covered in previous sections.
But anyway, now that we've seen a couple of quick but relatively reliable gauges for pricing growth, we should now turn our attention to inflation. And before we look at inflation itself, we need to look at its role in understanding bond yields. And we'll start off by breaking down the bond yield into its two most commonly quoted components.
Firstly, the actual or often called nominal yield is what you see quoted most frequently. In April 2022, the US 10 year yield was approaching 3%. However, that's broken down into those two components. The real yield is that yield less inflation. Most people would use an expectation of 10-year inflation called the break even as the basis for the inflation component. This is then subtracted from the actual yield to create the real or inflation adjusted yield. So although yields have been rising in 2022, real yields have remained very low because of that rise in inflation expectations.
And now onto some other forecasts for inflation. And in a similar vein to the Atlanta Fed's GDP forecast, the Cleveland Fed has a tracking model for estimating inflation which is also worth keeping an eye on. If you go back and view the historical forecast of previous quarters, you can see that it was often very close to the actual data when it was released.
But perhaps the most commonly watched gauge is that so-called break even inflation rate that we just mentioned earlier. This provides a live market derived view of inflation expectations. And it can be viewed over various durations, although five years is the most common. And you can see how inflation can be a product of nominal growth.
During the recession of 2020, inflation expectations expressed via the five year break even rate traded below 0.3%. But after the economic stimulus that followed, expectations surged to over 3% by late 2021. And the bond market adjusted to this. As inflation expectations rose, so too did nominal yields as traders began pricing in a hawkish policy response from the Federal Reserve to bring things back under control.
But whilst inflation can be coincident with growth, sharply rising inflation could also be the reason why growth peaks as we've seen with that long term chart of CPI and recession that we showed in a previous episode. And looking at the same chart of five year break evens but this time with the ratio of inflation protected bonds or tips to nominal treasuries, you can see that they are basically the same chart. Tips will outperform as inflation expectations rise and generally under-perform their nominal equivalents as inflation subsides.
Unless you are invested in inflation protected securities, inflation is the enemy of the bond market. It seems crazy that investors were once prepared to buy 0 or negative yielding bonds with maturities as long as 10 or even 30 years only a few years before inflation surged following the pandemic. And that serves as a clear reminder of how important it is to have a view on inflation as a bond market investor.
But there are a couple of final concepts that I want to touch on in this section. The first concerns central bank policy. Central banks including most notably the Fed bought a colossal amount of bonds during the various phases of QE in an attempt to lower yields and stimulate the economy. Their buying supposedly kept interest rates artificially suppressed as they were undoubtedly responsible for the biggest flows in the market, although the relationship between the actual buying in the market and the direction of bond yields has not been as clear as many would have expected.
Generally, when central banks have been buying bonds, yields actually rose, and vise versa. The exact opposite of what many people would have expected. But nonetheless, during the overall era of QE, the asset purchasing programs, yields were generally still in a secular decline. In 2013, however, the Fed announced a tapering of their bond purchases. And this was met with volatility in the market as it threatened to destabilize the conditions that had been created over the preceding years.
And just think. In terms of positioning in other classes, we often focus on hedge funds and other speculators in the future's market. And we have seen how they can still drive things to extremes. But in reality, it's the central banks like the Fed, the ECB, and the Bank of Japan along with some of the major pension funds like the Japanese government pension fund that are some of the biggest players here. Policy intervention like this has undoubtedly had an effect on investors' appetite for risk. You sometimes hear it referred to as the reach for yield, meaning that if the risk free return on government bonds is low or falling, then investors will look to high yielding alternatives in typically riskier bonds.
But we should, however, be wary of applying the same logic of the last 20 years of inflation moderation to an era where inflation may now be coming structurally higher. As we mentioned earlier, government bond yield curves are often the anchor of other interest rate products. And this plays out as relative interest rates or yield spreads between, say, corporate bonds and treasuries. Assuming everything else was equal, why would you take on the additional risk of a corporation defaulting on its bonds over that of a government bond, which theoretically should never go bankrupt?
Here you can see how these spreads reflect credit conditions in the bond market, which are largely driven by the policy decisions of central banks. As business conditions deteriorate let's say into a recession like the one we saw in 2008, then corporate bonds will look like a risky place to be compared to the relative safety of treasuries. But as the economy returns to growth, along with the return of animal spirits amongst investors, then there will likely be more demand for those riskier assets.
But that said, the eurozone government bond crisis led to a re-evaluation of the risk free rate. Quality triple-A corporate bonds are often considered safer than many governments. And that hunt for yield over the last 20 years has tightened the spreads of many low quality companies to unprecedented levels.
And another example can be found in the spread between junk and investment grade bonds. Junk bonds are defined as having a credit rating of double-B or lower and are regarded by the agencies such as Moody's or Standard & Poor's as being highly speculative. And the key here is that term "speculative." They are not regarded as investment grade, which suggests that the decision to buy bonds of this nature is more likely to come when investors want high beta plays on the bond market whether it's expressing a view on growth, inflation, credit risk, or central bank policy.
While there are, of course, micro fundamental factors beyond the scope of this workshop, you will be in a great position provided that you understand the relationship between bonds and expectations for growth and inflation as well as the link between interest rate differentials and credit conditions and the reflexive nature of central bank policy. And if you don't, then you can always go back over this section again. And now for those of who like a challenge or only came to hear about Bitcoin, let's conclude with a look at crypto.
The world of digital assets is evolving as we speak. While traditional cryptocurrencies like Bitcoin and Ethereum are dominating the broader news flow, the space is evolving at a rapid pace. And many professional investors admit that they have to start picking a lane because it's too difficult to follow and have expert information on absolutely everything.
And this is a space in which there's loads of new terms and phrases. There's things like stablecoins. We've got decentralized finance or DeFi. There's Web3. I think pretty much everybody understands or at least knows gaming. Then there's nonfungible tokens or NFTs. People trying to get into the metaverse and DAOs.
And these are just parts of a growing ecosystem. And as with many new industries before, oftentimes this feels like the Wild West. And we're not here to really analyze specific projects or coins, though. The purpose of this course is to understand the core principles that transcend asset classes and also understand the relationships between asset classes. From there, you can dive deeper into anything specific that you're interested in.
So if we zoom out and look at the digital asset space from afar, we are potentially starting to see a very familiar picture. There's a cyclical trend that has been evolving but is increasingly resembling the ebbs and flows of technology stocks and the broader stock market in general. And the ongoing tactical rotations around sentiment and leverage, news, tweets, regulation, and other short term factors is also appearing. And the space is still incredibly speculative. So there's lots of sudden sharp moves. And these are very, very common. So let's unpack each one of those.
There are undoubtedly clear secular drivers supporting the adoption of digital assets even with the ebb and flow of speculation along the way. And these are the fundamentals that we should focus on here rather than getting lost in all those debates. Is the number of people owning any crypto assets globally growing? And some people compare this level of adoption to the internet back in the 1990s or to the adoption of mobile phones. We will see if the analogy holds. But in any case, the space is not even at 10% of the global population yet. It's still early as people from that world like to say.
Now, the second chart tracks the total market capitalization of all crypto assets including stablecoins and tokens. Although it's strongly correlated to the performance of Bitcoin, there are numerous other crypto assets that have gained market share. Bitcoin's dominance has been decreasing, which is what you'd like to see in a growing industry. But it's in the decentralized finance space that many people see the best opportunity currently. And that's even if you were late to the Bitcoin party.
Now, looking at the total value locked or TVL enables you to gauge the growth in what traditional finance might be more familiar with as AUM or assets under management, the money invested in these projects. There is considerable scope for this area of the market given the secular adoption of crypto and more importantly its underlying technologies.
So let's recap. Total users, active users, and overall market cap of the space have been consistently growing. This is what a secular trend looks like. We have seen similar dynamics before in other industries like commodities back in the early 2000s when the demand from China and adoption from institutional investors supported prices for years ahead.
And can this change? Well, absolutely. Nothing is static especially in a field that is evolving at such a rapid pace. And as we keep reiterating, you have to continuously test your assumptions and also your framework. And there will be tremendous volatility along the way, which brings us to the cyclical view. Like it or not, the Fed's actions drive virtually any asset class you can think of whether it's the S&P 500, interest rates, or housing, and, yes, increasingly digital assets.
As much as the case has been made for crypto being a store of value and a diversifier of portfolios, the reality is that the more the space is growing and traditional asset allocators are getting involved, the more it is becoming correlated to the traditional market and liquidity. It is a little bit perverse because we want larger institutions to be involved. But the more they're getting involved, the more cyclicality is introduced to the space as they are more interested in cross asset correlations and portfolio construction.
If we take Bitcoin as a proxy for the space and looked at it against the NASDAQ 100, the relationship during the pandemic is pretty clear. If we look to the relationship between high volatility stocks in the US versus low volatility ones using two ETFs, then we can isolate risk on versus risk off periods. And you can see how Bitcoin has moved in tandem with that ratio of high beta to low volatility stocks, suggesting that in cyclical terms, liquidity is indeed a major determinant of price as with many traditional assets.
And it wasn't always this way. But along with the levels of adoption and the rate of technological change, this should be a key consideration when looking at this fascinating asset class. So even though you might be investing for the long term, it's always worth considering where in that cycle we are in order to optimize both your entry and your exit.
Valuing individual asset classes is a huge topic. In this module, we focused on identifying the common drivers behind asset price performance to help you build a strong foundation that you can leverage into further and explore the assets that interest you. We focused on helping you gain a better understanding of all the asset classes and, just as importantly, the relationships between them. Understanding the interactions between and among asset classes can help you find relationships that lead to future investments.
It's OK if you still have questions and are mulling it over in your mind. This is just the start of an ongoing journey of understanding of this incredibly interconnected web. The good news is you're not alone in this journey. So please keep sharing your thoughts and ideas with the RV community.
And my mission for you this time is to go on a journey across that asset class universe. Open up a stock index of your choosing and delve into its breakdown. What sectors do you think are dominating? And what stocks are in the top 10? And then pick one of those sectors and repeat the exercise. Chart the relationship between a sector and the market. Can you find anything interesting in there?
And also pick a country of your choice and check what drives its economy. Is it sensitive to commodities? What is the currency doing versus another major currency? And can you think of a reason why its currency might be doing that? And do you have any immediate hypothesis? There's plenty for you to work on. So until next time, thanks very much.