The beginning of the end for QE?

What has happened?

The yields on global government bonds surged in May, as nervous bond investors sold out, following Federal Reserve chairman Ben Bernanke's warning that the US central bank may soon start "tapering" ie, slowing down and preparing to cease its open-ended programme of quantitative easing (QE) bond purchases. (Bond yields move inversely to prices.) The sell-off delivered a sobering jolt to investors who traditionally think of bonds as a safety-first holding for long-term portfolios. However, several market commentators believe that rising yields are a good sign.

Jim O'Neill of investment bank Goldman Sachs, for example, regards the rise in yields as marking the start of a return to economic normality, and recently argued that as long as it takes place against a backdrop of recovering confidence and a gradual fall in unemployment, it will be no bad thing. Paul Krugman, too, argues that rising yields (like rising stock prices and a rising dollar) reflect a more positive view among investors in the American economy, and are no cause for alarm.

So what's the problem?

Plenty of others are scared witless. Pessimists worry that if the mere talk of 'tapering' can upset markets so severely pushing up yields and volatility not just in America, but in other major global markets too then the chances are that there is even worse ahead as QE is actually unwound. Since no one really knows to what extent central-bank actions have affected global financial flows and underwritten asset prices since the 2008 crisis, there is no way of predicting what will happen in reverse.

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"I can't say where, but there will be unexploded bombs going off as yields start to rise," reckons Kevin Gaynor, global head of asset allocation at Nomura. This uncertainty, and the parallels with today's long period of unchanged low rates, have led some to fear a 1994-style bond crash.

What happened in 1994?

After holding its target rate unchanged for the whole of 1993, the Federal Reserve surprised the financial markets with a rise of 25 basis points in February 1994, followed by similar rises in March and April. It then continued tightening, with 50 basis point jumps in May and August and 75 points in November. Overall, the Fed funds rate doubled from 3% in February 1994 to 6% just 12 months later. In one of the biggest ever bond-market sell-offs, the yield on US Treasuries leapt up in response (the yield on 30-year Treasuries rose by 200 basis points two full percentage points over nine months) as did corporate yields and mortgage rates.

What was the Fed thinking?

Then-Fed chairman Alan Greenspan expected that his initial modest precautionary rise in short-term interest rates would head off inflationary expectations as the US continued to recover from recession. He believed a small rise in rates would be seen by the bond markets as a prudent restatement of the Fed's anti-inflationary credentials, helping to reduce long-term rates. Instead, markets took fright: prices at the long end of the yield curve tumbled (so yields jumped), leading to the dumping of bonds in Europe and east Asia as well as America in a global trillion-dollar "bond-market massacre" that exposed the high levels of leverage (borrowed money) being deployed in the market. Powerful Wall Street players made huge losses, hedge funds imploded, and brokerages went bust.

Could it happen this time?

There's little doubt US Treasury yields will rise, but the distress caused is unlikely to be on the scale of 1994, reckons Goldman Sachs. Firstly, the Fed is actively signalling its future plans, rather than seeking to surprise the market (as Greenspan did). Also, the taper' isn't all one-way the Fed could always act to moderate the pace of yield increases if necessary by increasing QE. Secondly, there is far less leverage in the bond market than there was in 1994. Also, those holders who are leveraged (such as banks) have a significantly smaller portfolio weighting in US Treasuries than they did. So although the bond market is far bigger, it is likely to prove more stable.

So everything's fine then?

Well, not everyone agrees. As Stephen Foley says in the Financial Times: "the scale of the current bull market means that its end could be far more serious than anything seen in 1994". For one thing, in 1994, the Fed hadn't been buying up Treasuries. For another, interest-rate-sensitive markets have grown hugely: the value of outstanding bonds, $37.7trn (at September 2012), is 3.5 times the size it was in 1994. Moreover, many more hedge funds are betting in the bond market all of which adds up to a volatile situation (see below).

What it could mean for your investments

If bond yields rise a lot it might not be just the value of bonds that falls. Rightly or wrongly, government bonds have historically been seen as risk-free investments. The yields they offer are used to price other investments. The more risky the investment, the bigger the yield premium needed over government bonds. So if bond yields go up the yields on shares and property may have to go up too, meaning their prices have to fall perhaps by a lot. If bond yields are rising because the economy is recovering then stock and property markets may not suffer much damage. The real fear is that, if central banks lose control of the bond markets before recovery appears, stocks and bonds could crash together.