A few weeks ago, US bond fund manager Bill Gross said that he reckoned the great bond bull market of the past 30 years was over.
More specifically, he said it had ended on 29 April.
Now Gross – like any other high-profile investor with the ear of the public – has been known to talk his book. He’s also – like anyone else – far from infallible.
But so far this call is looking pretty good. Last month, global government bonds suffered one of their worst months in decades.
Is this the start of something big? And what should you be doing about it?
Central bankers are losing their grip – and that’s got everybody worried
May was a wobbly month for global stocks. Japanese stocks began plunging back to earth after their recent rocket-fuelled rise. And on Friday, at the tail-end of the month, US stocks had a nasty topple.
Lots of people are pinning the blame on ‘end of month window dressing’, where fund managers lock in profits they’ve managed to make. (My colleague John Burford gives different view on why the US market might have topped for now in his free trading email, MoneyWeek Trader).
Anyway, so investors have been a bit distracted by action in the stock markets, which tend to grab all the headlines.
But the real action last month was in the global government bond markets. Put simply, their monthly performance was atrocious. As JP Morgan points out, “the only materially worse months for government bonds in the past 20 years were February 1994 (on Fed tightening) and July 2003”.
In the US, for example, the yield on the US ten-year government bond rose from 1.6% at the start of the month to 2.1% on Friday. In other words, the price fell sharply.
So what’s going on?
There are two obvious – and related – drivers behind the rise in bond yields. Firstly, Japanese government bonds (JGBs) have become much more volatile. And little wonder. The Bank of Japan’s policy of seeking inflation should be bad news for bonds. At the same time, the Bank is buying bonds to deliver that policy. Investors still can’t seem to quite work out if they should be holding bonds or selling them.
Secondly, the Federal Reserve in the US suddenly seems much less united and sure of itself. Ben Bernanke and his colleagues can’t seem to get their story straight. Investors are suddenly worried that they might pull quantitative easing any minute now.
Arguably, you could say that the real problem for bond markets in May is that investors suddenly became less sure of what central bankers are aiming to do. This managing of market expectations is a key – and probably under-appreciated role – of central bankers. (On a side note, if you want to learn more about this side of things, check out these pieces on monetary policy by my colleague Seán Keyes – Should central banks target growth? and The case for replacing Mervyn King with a robot.)
But what does this mean for investors?
Is the glass half-full or half-empty?
As Gavyn Davies notes in the FT, the ‘glass half-full’ view of the bond market is that ‘normalisation’ is a good thing. On this basis, bond yields are rising because the economy is getting healthier, and investors are becoming more optimistic. Paul Krugman argues in The New York Times that a rising dollar, rising bond yields, and rising stock markets, indicate that investors are feeling more upbeat on the US economy, rather than anything more sinister.
Of course, Mr Krugman’s piece was written before Friday’s late-night plunge in the Dow. Which brings us to the ‘glass half-empty’ view of the bond market.
Under this view, the main reason that bond yields are low, is because central banks have been driving their prices higher by buying them. If central banks stop buying bonds – or investors simply lose faith in them – then we can expect a rapid sell-off, a spike in interest rates, and most likely another financial crisis as a result.
As highly-respected value investor Seth Klarman has put it in the past: “The rush to the exits will be madness, as today’s clarity will have dissolved, leaving only great uncertainty and probably significant losses.”
So which will it be?
Davies argues that: “If the great bull market in bonds has now ended, which it probably has, it may be followed by a long and grinding bear market, rather than anything more dramatic.” Gross has a similar view.
Why the slow and steady route? Well, basically because that’s what central bankers want. The Fed has hinted that it wants to avoid a repeat of 1994 (when a surprise quarter-point interest rate hike by the Alan Greenspan Fed sent markets into a spasm of panic).
The trouble is, this puts a lot of faith in the ability of central banks to control their respective bond markets. And I don’t think that you can take that as a given. I’m sure that Japanese, for example, didn’t set out to spark panic in the JGB market. And you only need to look at what’s happened to the Japanese stock market to see how that panic can have a knock-on effect on other markets.
Moreover, there’s a difference between an uncontrolled panic that forces central bank intervention, and a volatile, painful, but acceptable adjustment. A lot of investors seem to have come to believe that the Fed’s job is to protect them from ever losing money. That isn’t the case.
This quote from Fed member Richard Fisher in the FT this morning is a reminder of that fact: “In the best of all worlds, you have a period of slow but positive returns. But my experience is that markets overshoot on both sides. What I worry about is the little guy who gets sucked in at the end.”
The truth is, a bond market crash would hurt everything. As Kevin Gaynor of Nomura tells the FT: “I can’t say where, but there will be unexploded bombs going off as yields start to rise.”
I don’t think you should rush to turn all your assets to cash. This could easily be a false alarm. And I imagine that central bankers are already trying to find a way to wrestle back control of the market.
But in terms of protecting yourself, there are a few points I’d make. We’ve already argued that you should avoid conventional government bonds. ‘Junk’ bonds and all those other high-risk bonds are probably worth avoiding too. Naturally, the yields on these are influenced by the yields on government bonds – if they rise, so will the yields on junk.
I’d also be wary of exotic or illiquid asset classes in general. You can expect life to get very volatile. And if ‘unexploded bombs’ go off, it’ll be in the least transparent assets. You want to be in a position where you can liquidate your holdings when you need to without paying too much of a penalty in the process.
For example, our guest speaker at the MoneyWeek conference, Russell Napier, warned attendees not to touch emerging market bonds with a ten-foot bargepole, and I’d concur with that. (Please note, I’m not including Tim Price’s regular ‘Wealthy Nations Bond’ fund tip in this category – those economies actually have the assets to back their debts).
To see Russell’s views on where the next big crisis is coming from – not to mention all the other great talks from the other speakers at our 2013 conference – you should MoneyWeek conference.
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