Global bond markets have had a terrible year so far.
To take one measure cited by FT Alphaville, the Bloomberg Global Aggregate bond market index has fallen by more than 11% since its peak in January 2021, which is “the biggest setback since at least 1990”.
Yes, I realise that for those of you who focus on equities, that doesn’t sound like a big deal. Sometimes equities can lose that in a week, and you just have to suck it up.
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But believe us, this is a big deal for bonds.
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Bonds are struggling because investors believe that inflation is real
To take another measure of how bonds have struggled in recent years, Louis-Vincent Gave of Gavekal points out that 30-year US Treasuries have shed 30% since their 2020 highs.
Oh and the recently-issued Austrian 100-year bond has halved in value from its 2020 high point.
Those are massive falls. As Gave puts it, “most major government bond markets outside China have delivered the kind of price behaviour last seen in 1994.”
That year saw an incident known as the “bond market massacre”, which was a formative event in creating the “bailouts at any cost” philosophy of Mr Alan Greenspan, the architect of our present financial tribulations.
Anyway, this is having some interesting side-effects. As Ft Alphaville points out, negative-yielding bonds are almost a thing of the past now. In 2020, the volume of bonds that charged you to own them peaked at almost $18trn.
Now, there’s just $2.9trn of these collectors’ items out there (quick! – someone turn them into NFTs, you’ll be able to lose twice the amount of money in half the time).
Half of government bonds traded on negative yields in August 2019, according to Matthew Hornbach of Morgan Stanley. Now it’s just 7%.
That’s all very interesting, but what does it mean?
It’s really just an extremely vivid portrayal of how the environment has changed. The “long duration/jam tomorrow” bubble has well and truly burst. Deflation is no longer the bogeyman for investors.
The big shift now is that they’re starting to become properly unnerved by inflation. And that’s going to cause some tricky balancing acts for governments and central banks.
Why the Japanese yen is confusing investors
Perhaps the clearest demonstration of this lies in another intriguing shift in financial markets today – that is the behaviour of the Japanese yen.
Usually, when things are going wrong in markets, the yen gets stronger. It’s historically been viewed as a “safe haven” currency.
This used to baffle investors – Japan has always had ugly-looking public finances, so the view of the yen as somewhere to take shelter always seemed odd to many.
Now, though, investors are surprised to see that rather than strengthen, the yen is weakening fast.
For all the confusion, there’s a clear reason for this: every other major central bank is either raising interest rates or talking about it, but the Bank of Japan has no plans to budge.
Usually, if one central bank is running looser monetary policy relative to another central bank (as the Bank of Japan is relative to the US Federal Reserve, for example), the currency with the profligate central bank will weaken versus the one with a slightly more vigilant guardian of its currency.
Hence the slide in the yen versus the US dollar.
However, there’s another wrinkle here. The Japanese central bank operates a policy of yield curve control. This involves controlling long-term interest rates by setting a target yield for specific bonds, and promising to print whatever money is necessary to keep the yield at that level.
The Bank of Japan introduced this policy in 2016, when it said it would target a 0% rate on the ten-year government bond yield. The irony is that when this target was set, the bank’s goal was arguably to keep the ten-year yield from turning negative (bad news for bank profits), rather than keeping it from rising.
However, now bond yields around the world are going up, and Japanese government bonds are no exception. That has led to the Bank of Japan stepping in today to enforce a cap on yields of 0.25%.
The thing is, if you print money to cap yields, you batter your currency – and that’s exactly what’s happened.
We’re talking about the return of the “yen carry trade”, whereby cheap money makes its way out of Japan (and thus out of yen) and into higher-yielding assets elsewhere. This was all the rage in the days before the financial crisis; it was one of the things driving asset prices higher.
It was also one of the things that exacerbated the savagery of the collapse, because the risk is that everyone has to liquidate their trades at once, which then sends the yen much higher again, and destroys any profits made on the trade.
What might happen next? The Bank of Japan seems determined to defend the yield peg. Inflation is picking up in Japan but it’s nowhere near levels in other parts of the world.
But this is a tricky balancing act. How far do you let the yen go before the collapsing currency becomes a problem? And when you decide the yen has fallen too far, how far do you let Japanese bond yields rise before you step in there too?
I suspect this is just a preview of the wrestling match that central banks in the US, the UK (and the eurozone) are about to face too.
The choice between interest rates and currency is likely to require some sort of global co-ordination – one way to avoid a given currency collapsing is for everyone to weaken at roughly the same pace.
I suspect this world – one where all currencies come under pressure – is good in the long run for gold. But we’ll see.
