12 Jan 2018

A little fear is no bad thing .....

ref :- "Watch the bond market, not equities" , Comment by Gillian Tett in the Financial Times

On Wednesday we brought up the question of whether  a significant rise in bond yields might cut the legs from under the stock market, as Jeff Gundlach believes it will in the second half of this year. It was a long-held if slightly simplistic market adage that rates of interest and equity prices generally move inversely, and in truth in broad terms it was an accurate one. Not now though ...... the Fed has raised rates five times in the current cycle, and thinks it most likely that it will do another three times this year. Under the old rules that would be seriously bad news for equities, and yet in reality the opposite is true : stock markets continue to reach for the sky.

There are a number of powerful reasons behind the equity boom, even if you are one of those who worry about it getting overcooked. But as far as the rates higher / stocks lower argument goes, the reason why that theory has gone astray is of course because although short-term rates are climbing, by historical standards longer-term bond yields are still extremely low. That naturally means that the yield curve is flattening, and since the curve and longer yields make up a sizeable proportion of any measure of financial conditions, those financial conditions (as opposed to short-term rates) remain very close to being at their most accommodative, historically speaking.

The task that faced the Fed (and is about to be taken on by other central banks) is to gradually withdraw the stimulus injected after the financial crisis and ultimately return to more "normal" monetary policies WITHOUT panicking investors. A gradualist, market-sensitive approach and good "forward guidance" has allowed them to achieve this with seemingly barely a flicker of concern among investors so far. But a wobble in the bond market that has seen 10yr yields rise towards 2.60% at one stage raises concerns about where we go from here, and whether the long bull market in bonds is in fact over. Plainly Mr Gundlach thinks so, as does rival Bill Gross and other market heavyweights.

The Fed might not be displeased with high-profile sages expressing such views, in that the more prepared that investors are for what's coming, the more likely they are to take it in their stride. And even if it's true that what constitutes a  "normal" rate structure will be lower than we were used to, some adjustment to the upside is inevitable. These ultra-low rates, if left in place for the longer-term, do damage to the financial infrastructure (not just banks' share prices) and breed potentially disastrous asset bubbles. Handled with care, there's reason to think that a steady rise in rates and yields is not only desirable but should also be eminently manageable with undue market reaction.

Anything unexpected  --  in terms of the pace, size or likelihood of rate hikes  --  well, that could provoke something far more explosive, and not in a good way for markets. You don't necessarily have to be bearish to recognise that these bond markets are vulnerable (though it helps). They're vulnerable because inevitably some investors will be complacent after such a long period of ultra-low rates. They're vulnerable because investors, driven by the search for yield, have taken on bigger credit risks susceptible to upward moves in rates. And they're vulnerable because they've used derivatives to magnify their exposure (and potential return).

And it's not just investors ..... leveraged corporate borrowers should fear a panicky spike in yields. Governments too ,,,, the Congressional Budget Office calculated that costs on the US federal debt will rise from $270bn to $712bn over the next decade if 10yr yields were to rise from 1.8% to 3.6%  --  and that was before the likely rise in the deficit resulting from President Trump's tax cuts. If such a spike in yields was to happen in just one year, that could spell trouble.

If that sounds a bit dark, we should remind ourselves that so far the bond market has handled rate hikes with absolutely no sign of distress, or even undue discomfort. It's possible that the factors that have kept yields so low, such as mysteriously low inflation and remarkable investor appetite, will continue to exert their benign influence. But given what's at stake, the authorities might be grateful that the potentially adverse effects of their policy path could be cushioned by the advance warnings of Messrs Gundlach, Gross and Co.

10 Jan 2018

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