Expect more turbulence as the market calls central bankers’ bluff

US markets have seen sharp falls

(Image credit: © JOHANNES EISELE/AFP via Getty Images)

published 26 February 2021

Are we heading for another bond market tantrum? The most important economic trend of the last 40 years is about to reverse

You know that market tantrum I mentioned yesterday? It looks like we did end up getting a taste of it. The US Nasdaq index dropped sharply as bond yields in the US (and elsewhere in the world) rose sharply. So what happens next?

Bond yields spiked yesterday, with the ten-year US Treasury rising above 1.6% at one point. In absolute and historic terms, that’s still one of the lowest levels on record.

But it’s not about the level. It’s about the direction and the pace of move in that direction. We’ve been used to bond yields going down for about 40 years. The reason markets get twitchy when they move in the opposite direction is because it would have massive implications for everything else. It would mark a reversal of the single biggest trend in financial markets for almost everyone’s entire investing lifetimes. It’s a big deal.

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Central bankers are not going to go Volcker on us any day soon

The reason yields are going up now is because investors are starting to think that inflation will return, and not just in the short term. The reason they haven’t gone up faster is because investors also think (or hope) that central banks will not react to inflation – they won’t raise interest rates. In fact, investors hope that central bankers will repress interest rates.

So will they? I suspect so. Since 2008 (if not before), the Federal Reserve has only become increasingly willing to step in and smooth away any problems that threaten to derail the bull market in shares. You need only look at the reaction during the pandemic to see that. A flood of money, not just into the US but globally, with virtually no questions asked.

So is there any chance that this Fed is about to pull a Paul Volcker, and send rates right up to stifle rising prices? No chance. Not least because Volcker only did what he did (hiking interest rates to punishing levels in the early 1980s) because inflation was rising at double-digit rates. You could certainly argue that he took the tough decisions but you could also argue that he didn’t have much choice. All of his options were bad.

Anyway. Central banks have said that they’re not fazed by inflation and that they want to focus on growth. So if rising borrowing costs (ie, higher bond yields) threaten that growth, they’ll have to step in and do something about it. The question is the timing. Central bankers don’t want to admit that they’ll “do what it takes”. They’d rather that the market trusted them to be pro-inflation, rather than get into the politically difficult territory of spelling it out.

The problem is that, markets being markets, they’ll force central banks to prove the point. They’ll push this until the banks push back. But that means that we’ll need to get a bigger correction. Because that’s what the central bankers will need to happen before they can justify acting.

Be prepared – we might get some buying opportunities before too long

The thing about corrections is that they pull down just about everything. I’ve been watching the FTSE 100 with interest, for example. In the last month, the FTSE has outperformed the US tech index quite strongly.

This is what I’d expect to happen, given that one index (the tech-heavy Nasdaq) doesn’t like rising bond yields whereas the bank-heavy FTSE 100 is much more open to them. However, at the same time, you’re not going to be jumping with excitement if you’re a FTSE 100 investor, because you’re only flat on the month. It’s just that this is significantly better than the 5% loss a Nasdaq investor has had to put up with.

My point is that when investors enter “sell” mode, they sell fairly indiscriminately. The US is the world’s most important market, so in the short term it doesn’t matter that it’s way more expensive than any other market – where it goes, others will follow. It’s just the way it works.

It’s also worth remembering that because of where we are in the cycle – extreme exuberance and rampant fear of missing out – an awful lot of people have bet on the world’s most popular stocks with an awful lot of borrowed money. Some of these investors have no margin of safety whatsoever. Their only strategy is to sell any good stuff they own to meet margin calls and also try to average down on the riskiest stuff that they own (which is suddenly entirely illiquid in practical terms because no one wants to buy it) and hope that it goes up.

As the saying goes, hope is not a strategy. So you get forced selling, knock-on effects, things start to break down, and usually that’s when the central bank panics and steps in – we’ve all been here before. So don’t be surprised if things get a little bumpy in the coming weeks.

However, it’s also during these little periods of panic and dashing for liquidity that the well-prepared investor can find themselves the odd bargain, as long as they’ve done their homework in advance.

So what should you do? As I’m always saying, have a plan. Have a watchlist of stocks or assets that you would like to buy and hold for the long run. When you spot them being sold for appealing prices because someone needs to sell the family silver in order to pay the rental fees on their deep-in-the-red Tesla shares, that’s when you step in to take it off their hands (this by the way, is why you always make sure that part of your portfolio is held as cash. So you can take these opportunities when they arise).

So that’s it. If you don’t have a plan, why not set aside some time this weekend to build a watchlist and review your portfolio, and consider what you think it should look like versus what it currently looks like? We’re still in the calm before the storm here. It’s better to have a plan in advance, rather than try to cobble one together mid-panic.

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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.