It is unlikely that anybody working in a dealing room today has ever seen a bond bear market. Yields on ten-year US Treasury bonds hit their secular high of just under 16% back in 1981. As the outlook for inflation then moderated across the world, bond yields started to fall… and kept on falling for more than 30 years.
In July 2012, ten-year US Treasury yields had reached a record low of just 1.4%. Since then they have moved higher, but only gently. However, there are disconcerting signs, notably in the eurozone, that the long-term outlook for bond markets has worsened dramatically.
Central banks don’t have your back
As a former bond salesman, it always struck me as odd that just as the supply of government debt reached all-time records, the prices for that debt also reached all-time record highs. But we know, of course, that after the financial crisis of 2007-2008, trillions of dollars, pounds, euros and yen were put to work buying government bonds in a bizarre experiment to test the efficacy of trickle-down wealth. And I have long maintained that there is one thing riskier than investing in a free market: namely, buying a rigged market in the belief that the central bank has your back.
The various iterations of quantitative easing (QE) clearly boosted stock prices, and facilitated a culture of easy money that suppressed bond yields below their “natural” level. (The lack of solid economic growth around the developed world suggests that this experiment failed to achieve anything other than this bubble in the prices of financial assets.)
But it always felt as if Mario Draghi’s embrace of QE on behalf of the European Central Bank was a day late, and a euro short. Eurozone QE always felt like an egregious version of “greater fool theory” – the greater fool being Draghi himself.
And this may now have run its course. The German government bond market is behaving with all the price volatility of a dotcom stock. As recently as mid-April, the price of the long bond in Germany, which matures in 2046, stood at nearly €160 (putting it on a yield of under 0.5%). By mid-May it was down to €130 (taking the yield up to around 1.25%).
By early June, after some erratic bounces, it was down to 120 (and a yield of around 1.7%). To lose €40 points in price in a matter of weeks is unprecedented for any developed bond market.
Given that the German bund amounts to the “risk-free” rate for the entire eurozone, this is an alarming state of affairs. And naturally enough, the yields on other eurozone bonds have spiked in line.
French ten-year government bond yields are up by almost one percentage point in the same period, and Italian ten-year yields by more. It’s possible that the spike could turn out to be a moment of midsummer madness, in which case there are fewer grounds for concern. But even then, the bout of volatility is likely to have fatally mauled the more highly leveraged players in the market who happened to be long eurozone bonds.
However, if it turns out to be the early stage of a secular bear market, the implications are sobering. The long bull market for interest rates, inflation and bonds over the last 30 years or so was also the primary driver for the long bull market in equities. The bond world, by way of market value, completely dwarfs the value of the listed equities market worldwide. So if we are at the early stages of a bond bear market – and the jury is still out – then the implications for equity investors are hardly positive.
Reasons to be fearful
In any case, heightened price volatility is rarely a positive development, especially in a financialised world where the collapse of Lehman Brothers has made us all aware of just how interlinked our modern asset markets are. And it’s not as if there is nothing to be worried about in the global economy.
Expectations for deflation were held as justification for ultra-low bond yields – but recent developments suggest those fears are abating. That may mean that inflation starts to looms as public enemy number one, some 30 years after it last held that role, joining a long list of other worries. The markets were already fretting about the timing and extent of a rise in US interest rates.
Those fears are now being accompanied by fears over “Grexit”; a possible Greek default; the knock-on effects on confidence in the eurozone; contagion across the eurozone periphery; the impact of a strengthening US dollar on emerging-market borrowers in that same currency; the credit bubble in China… and more.
We live in a world replete with potential crises. With policy rates still near zero and the QE arsenal already fired, the central-banking toolbox to tackle them is almost empty. Summer in the City is going to be interesting.
• Tim Price is director of investment at PFP Wealth Management. He also writes The Price Report with Doug Pritchard.
Category: Market updates