Are we headed for a bond market bloodbath?
- 20 March 2017
- From the section Business
The greatest bull market in history is over. Last week's rise in US interest rates confirms the reversal of a 30-year trend, and that spells big trouble according to some Cassandras.
There have been bumps in the road along the way but the market for bonds - IOUs issued by governments, banks and companies to raise money - has headed pretty much in one direction for those 30 years.
As the dragon of inflation which roared in the 1970s has been slain, the predictable returns of bonds - their "fixed income" - has been less prone to erosion by higher prices and so they have become more and more attractive.
The recent threat of a global financial meltdown stoked the long-term bond buying frenzy in two ways: First, it led to a rush for the safest investments in the world. Some safe-haven investments - like German government bonds - became so popular people were prepared to accept a negative return (essentially paying £11 for a £10 note) knowing that if the proverbial really hit the fan they at least trusted the German government to give them most of their money back.
That rush to safety was further compounded as governments around the world pumped trillions into the financial system by printing money and using it to buy bonds from their existing owners (usually banks). The supply of money exploded and the stock of safe bonds available to buy shrank. Bond prices rocketed.
Different this time?
It's important to recognise that every few months for the last five years someone has said they think it's all over. Every few months they have been wrong and borrowing costs have headed down again.
But there are reasons to think that this recent fall in bond prices means it is over now.
Folks are selling bonds and buying shares.
Inflation, the mortal enemy of bonds, is on the rise around the world. That makes it more sensible to be in company shares as their value reflects the higher prices they are charging for their goods and services.
Hence stock markets have surged while bonds have fallen.
So what? - all perfectly normal and part of cyclical nature of economies? Perhaps not.
Such has been the magnitude of the bond buying binge, there are real concerns that its reversal will not be orderly.
For one thing, there is the issue of liquidity.
That's a measure of how much of something you can buy or sell without changing its price.
Oil, for example is a liquid market. It is needed all round the world so there are plenty of willing buyers and sellers.
You can buy or sell it by the tanker load without pushing the price up or down.
But even liquid markets can be tested by a couple of enormous sellers.
If you had bought 30% of the world's oil, you would find it pretty difficult to sell it again without pushing the price down.
That is exactly what the Bank of England did with UK government bonds - it bought over a third of them. Stock like that can't be shifted without a bit of sale.
Second, while the typical stock or share will trade nearly 4,000 times per day, most corporate bonds only trade about 70 times a day. If liquidity were to to dry up like it did in 2007-09, people who really, really wanted to sell would have to do so at knock down prices which would develop its own negative feedback loop as others who weren't previously spooked got spooked by seeing prices fall rapidly.
Traditionally, the big banks helped provide liquidity.
They used to have a big float of bonds and cash which they would buy and sell to help keep the market moving.
If you couldn't find a third party buyer - they would take it off your hands for a bit less and then sell it on to make a profit for themselves.
In the name of making the banks more stable, the years after the financial crisis saw a clampdown on banks buying and selling their own inventory. That float is gone.
The other way that many retail investors bought bonds was through something called Exchange Traded Funds or ETFs. As the name suggests they are bundles of assets, traded on a stock exchange, designed to reflect changes in the value of an underlying thing - like oil, or gold, or bonds.
When you own a bond ETF, you don't own any bonds - the person who created the ETF does.
If lots of people tried to sell their ETFs at the same time it would exacerbate the problems already discussed in the underlying bond market.
If you add all of these factors together then its not hard to see why many respected market sages are predicting a bloodbath ahead.
The closest recent comparison is the bond market "massacre" of 1994.
After a period of low interest rates to try and revive the economy after the recession of 1991-92, the US central bank started raising rates very quickly to head off inflation. Investors lost trillions, Orange County in California went bust and it triggered a currency crisis in Mexico.
Where's the pin?
Given that interest rates have been much lower for much longer than anyone ever imagined, many think this bath could be much bloodier this time around.
All the ingredients are there for a violent bursting of the bond market bubble.
Everything, that is, apart from a pin. In 1994, the then Fed Chairman Alan Greenspan provided it by aggressively raising interest rates over 2% within a year.
Current Fed Chair Janet Yellen does not look like playing that role now. Mike Amey of world's biggest bond investor PIMCO seemed sanguine: "The Fed prepared the market well for last week's rate rise and we don't see any reason for it to get more aggressive."
In fact, after rates were raised last week, Janet Yellen's outlook for the economy and inflation was a bit more tepid than many had expected which makes it less likely she would raise interest rates quickly.
But the fact that bond investors like Mike Amey are sanguine doesn't mean they are not vigilant. The fact that people continually warn about a massacre in itself makes it less likely to happen.
The amount and speed of information traders and investors now have is very different to 1994.
Back then, the Fed was much more inscrutable and rate rises were not even formally announced.
The wild card in all this is Donald Trump. If, as the stock market seems to be suggesting, he can really supercharge the US economy by cutting taxes and increasing spending, then the Fed may have to rethink its gradual approach to rate rises.
If that happens, the massacre could still be on.
If it is - borrowers like governments, companies, banks and local authorities may find out what Orange County did back in 1994. Namely, that the normal queue of people ready to lend you money to pay for the NHS, build a new factory, refinance your customers' mortgages or invest in social housing has suddenly disappeared.