Rising bond yields are unnerving markets and it could get worse before it gets better
With inflation returning fast, government bond yields are rising along with prices. And that's unsettling markets around the world. John Stepek explains what's going on.
A quick reminder before we get started this morning –don’t miss our webinar on Wednesday 20 October with BlackRock Smaller Companies trust.
I’ll be talking to manager Roland Arnold about his views on the outlook for the UK’s smaller companies against the current turbulent backdrop. Don’t miss it – register free here, and you’ll be able to watch it later even if you can’t tune in on the day.
Markets have been jittery over the past month. We haven’t seen a crash – or anything like a crash – but the relentless rise of the S&P 500, for example, has taken a bit of a knock. It last hit a new high on 6 September, and it’s been drifting lower since.
The best word for asset markets as a whole is probably “unsettled”. So what’s going on?
What’s rattling markets?
The pound has tanked in recent days. Energy prices are rocketing – oil hitting new eight-year highs, natural gas going through the roof. Gold is having a dreary time of it.
Equity markets are mixed – the FTSE 100 likes weak sterling and strong oil, so it’s doing better than most, but both the Nasdaq and the S&P 500 are struggling to regain their momentum, while Japan’s Nikkei is also wobbling around the 30,000 mark.
And then of course, there’s the big boss market of them all – the US Treasury market. US government bonds have been falling in price, which means yields have been going up.
As Dominic noted yesterday, this is not an easy environment for an investor to navigate. But what lies at the heart of this present discombobulation? I want to try to pick it apart a bit today.
Unless you’re a short-term trader, you really don’t need to worry about the odd bit of market quicksand. But it is helpful to wrap your head around the long-term trends so that you can work out if you need to make more significant adjustments to your asset allocation.
The big picture issue is straightforward: investors have grown used to trading in markets which are underpinned by the presence of central bankers who are willing and able to buy government bonds – the foundation assets on which all else rests – at whatever price is on offer.
This has suppressed volatility, and it has helped to keep interest rates low.
The one big risk to this comfy world is, and always has been, the return of inflation. If the outside world is disinflationary or even deflationary, then central banks can print what they like. You’ll create lots of distortions – rampant wealth inequality for one – and what Austrian-School economists would describe as “malinvestment”, but you won’t breach your inflation target. And that matters, because it means you can keep going with the money printing and the volatility suppression.
The problem now is that inflation is returning, and it’s returning fast. It’s already gone beyond the early definitions of “transitory”. Transitory no longer defines a specific time period so much as a specific type of inflation.
As long as soaring costs don’t get passed into the wider economy (mainly via ingrained wage rises), central bankers hope that supply chains will eventually fix themselves and that, in the meantime, they can wait it out.
But it’s clear that they are nervous about all this. The word “transitory” remains, but the more they say it, the greater the sense that they are just whistling past the economic graveyard.
This is why you are seeing central bankers still saying “transitory” even as they’re becoming steadily more hawkish at the edges. And the market doesn’t like that.
Bond yields could spike higher
One of the most obvious reflections of this is the rise in bond yields. The US ten-year bond has gone up from 1.3% to 1.5% in the last two weeks. That doesn’t sound like much, but it’s been quite a fast move, and when you have as much debt to roll over as the US does, every basis point (that is, 0.01%) counts.
This in turn is driving the US dollar higher (which, incidentally, is the more significant reason for the pound’s weakness – there are two sides to every forex trade, remember?)
It’s a very clear response to the fear that the Federal Reserve is going to start cutting back on the amount of quantitative easing (QE) it does (“tapering”).
Mohammed El-Erian, a man who presumably understands his bond markets, given that he was high up at bond fund giant Pimco for a long time, wrote about this in the FT yesterday.
The danger, he says, is that we might see “yields suddenly ‘gapping’ upwards given that we are starting with a combination of very low yields and extremely one-sided market positioning.”
Unfortunately, El-Erian doesn’t really have much to offer (in this piece at least) beyond diagnosing the problem. In effect, markets might have another taper tantrum.
So what would that mean? Central banks – the Fed specifically – will want any transition to go smoothly. This is why Jerome Powell, the Fed chair, has been at pains to emphasise that the taper is entirely separate to interest rate rises. He’s pitching it more as a way to unwind emergency support, rather than as a runway towards higher rates.
You can see why Powell might think this. Ironically enough, past doses of quantitative easing (QE) have in fact pushed bond yields higher, and they’ve fallen as QE has ended. However, I wonder if that environment has now changed. Back then, markets feared deflation. So when QE ended, they acted as though the economy was going to collapse and piled into the perceived safety of Treasuries.
However, if markets are getting worried about inflation – and they seem to be – then the risk is that QE is now suppressing rather than underpinning yields. In other words, the only thing stopping markets from pricing more inflation into the bond markets is the Fed’s presence.
What does it all mean? Well, I still suspect that when push comes to shove, financial repression will be the order of the day. Regardless of what happens with inflation, global bond markets simply cannot be allowed to reprice to more “normal” levels because that would literally bankrupt most nations.
There’s an interesting quote from Powell, speaking at a virtual conference of central bankers yesterday hosted by the European Central Bank. Powell was asked at one point whether the US had “overdone” it with public spending and monetary policy during the covid pandemic.
Here’s how he replied: “I think the historical record is thick with examples of undergoing it, and pretty much in every cycle, we just tend to underestimate the damage and underestimate the need for a response. I think we’ve avoided that this time.”
That’s very telling. I think it demonstrates where the central bank mindset is these days. We might be going through a wobble right now, but when push comes to shove, the instinct will be to step in.
We’ll probably need another market spasm before that. Maybe we’ll get one in October, as is traditional.
Anyway – if you haven’t already subscribed to MoneyWeek magazine, now’s probably a good time to do so.