Just before we get started – here’s what to take a look at on the website this morning… Max King looks at why investors should be paying close attention to Vietnam while David Stevenson tips a couple of investment trusts for the adventurous.
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Is this the big one? Is the bond bear market finally underway?
Bill Gross – the former “bond king” – thinks so. Moreover, so does the current monarch of the bond market, Jeff Gundlach.
So what’s got the bond gurus so convinced? And what does it mean for the rest of us?
There are very good reasons for bond yields to rise
This week, the yield on the ten-year US Treasury rose to just under 2.6%. That level was last seen nearly a year ago, when optimism over Donald Trump had hit its high point.
Why does that matter?
Bond yields have been falling (and, therefore, bond prices rising) for around 35 years. In other words, interest rates have been in a long-term decline.
That appears to be changing. Bond yields pretty much hit rock bottom in summer 2016. Now, bond traders are looking at the charts for some idea as to whether the trend has genuinely changed. Bill Gross and Jeffrey Gundlach – two of the loudest voices in the bond markets – reckon it has.
To be clear, this stuff is unscientific. Like most things in markets, it’s a combination of instinct, motivated reasoning, headline grabbing, and using a thick or a thin pencil to tell the story you want to tell.
However, there are plenty of good reasons to think that bond yields should be heading higher from here. This week just crystallised a few of them.
Firstly, central banks are slowing down or ditching quantitative easing. Even the Bank of Japan and European Central Bank look set to slow down. So a massive buyer of bonds is leaving the market. This was highlighted by a fairly minor technical change by the Bank of Japan this week, which rattled some investors.
Secondly, there’s a lot of bond supply due to hit the market this year. In other words, a lot of countries will be clamouring to borrow money, just as the least price-sensitive buyer is packing up and heading home. This was highlighted by a report – disputed by Beijing – that China is rethinking its own demand for US Treasuries.
Thirdly, global economic growth is strong – stronger than most had expected. If inflation can’t pick up under these conditions then maybe we just need to revisit all our assumptions about everything.
There’s certainly no consensus on inflation – our roundtable debated the issue in December – you can read that here.
Yes, but what does it mean for my money?
I’m not going to talk about your portfolio for now, because I don’t know exactly how this unfolds (obviously). But the key issue here is that bonds are a massive component of the financial system. They’re like the tectonic plates of the market, while equities are all dancing around – somewhat obliviously – on the surface.
Everyone has got used to the tectonic plates moving in one direction. Now they’re changing direction.
How does that unfold? On the one hand, these things don’t necessarily have to move fast. One thing that bonds have got going for them is that once yields rise (ie, prices fall) to a certain level, there will be a buyer.
You might not want a US Treasury at 2.6%, but plenty of people will queue up at 3.5%, for example (although to be very clear, that would be a huge move if it happened in a short space of time).
On the other hand, the whole mentality and structure of the financial system has been tilted towards products and strategies that work in a disinflationary, “Greenspan put” environment. The logical peak of this is the mania for “short volatility” investing – approaches that effectively bet on the market staying calm and getting calmer.
Given how these things normally work, I’d imagine there will be a few false scares and then a tipping point at which there’s an identifiable panic. I would think that would be caused either by a few significant inflation surprises, or something more dramatic that I haven’t thought of (perhaps a big buyer of US Treasuries really does turn around and do something unexpected).
The other thing you have to remember is that central banks don’t want this. If markets look as though they are having a “taper tantrum” again, the central banks will step in to calm their nerves.
Whatever they say, our central banks still want inflation to remain above interest rates (financial repression), because it’s the least painful way to get rid of all the debt that’s still hanging around.
In short, don’t imagine that the era of managing interest rates is over. It isn’t, not by a long chalk. And in fact, I suspect that if anything could give us the “melt-up” outcome, it’s central banks making it clear that they are going to ignore above-target inflation. The idea that they’re not only not taking the punchbowl away, but spiking it with rocket fuel, would be just the ticket for a final blowout.
This is probably the main reason that I’m optimistic on commodities right now. Inflation is good for them and relative to stocks and bonds, they’re very cheap.
So that’s what to watch out for – rising inflation and soothing noises from central banks.
And if you want to know what happened in previous bond crashes, here’s some background on the false alarm of 1994, and here’s what happened in the much more relevant late 1960s.