For quite some time, we have written about indifference to risk, unjustifiable asset prices in many markets, and high levels of liquidity all as different aspects of what John Authers called “overvalued credit” meaning overly bullish (more accurately speculative) conditions in debt markets which fuelled overheated conditions in asset classes that could be financed (and even some that couldn’t, like contemporary art).
After a series of stronger-than-expected US economic releases, global stock markets beat a retreat because interest rate cuts in the US now seemed unlikely. So far, this seemed like a normal, and probably overdue correction, given the robust gains of the last month.
But Thursday witnessed a spike up in bond rates around the world, and technical traders saw the move as significant from a technical standpoint, breaking a 20 year pattern.
Now this may prove to be another Feb. 27: a sharp correction that leaves the markets unsettled for a few weeks, with old habits reasserting themselves and lost ground recovered with surprising speed. It will be a few weeks in coming, but weak housing data plus ho-hum jobs growth could restore the picture of a weakening rather than a strengthening economy and again forestall the return to sobriety. The fact that so many people have been nervous about the markets says this may not be the final chapter of this bull market (typically, it’s when some die hard skeptics throw in the towel, which did happen towards the end of the dot-bomb era).
But we may have finally hit the inflection point that many people were expecting. People in the markets can feel when the winds shift. I was at Goldman in the early 1980s, and one particular day in August 1982 (I think it was the 12th) word swept through the firm like wildfire that the bear market (which had been hard on the firm and the industry)was over. And indeed it was that August that the great bull market begain. I’m too far removed to sense it now, but this could be one of those times. Certainly the Financial Times John Authers thinks so. In a FT video, he speaks of a pervasive sense that credit has gotten too cheap and inflation is a real risk.
In addition, because we have a lot of quick trigger investors who for performance reasons didn’t want to get out too early, we could have a more dramatic shift in performance and sentiment than one normally sees at the end of a cycle. We’ll learn in the upcoming weeks whether this was a mere tap on the brakes or the start of a serious slowdown. I suspect we have enough mixed to bad economic news in the offing, if nothing else related to housing, for at least one more rally before real bearishness sets in in the bond market.
From “Bond turmoil raises fear of end to easy credit,” in the Financial Times:
The benign credit conditions that have helped fuel the global buyout boom came under threat on Thursday as the yield on 10-year US government bonds registered its biggest daily jump in years.
Some analysts suggested the dramatic rise in yields could herald a sustained period of higher interest rates, increasing the cost of borrowing for companies, deflating borrower-friendly credit markets and eventually crimping the outlook for equity markets.
“Stocks need to reflect what bond yields are saying,” said Michael Kastner, portfolio manager at SterlingStamos. “Rate cuts have been taken away and if yields start to reflect that rate hikes are likely this year, then it will get pretty ugly for stocks.”
The yield on the 10-year US government note hit 5.14 per cent in New York trading, marking the biggest one-day advance in several years, before settling back to 5.10 per cent. That brought 10-year yields above those on shorter-term Treasuries, restoring a more normal – that is, “steeper” – yield curve.
For much of the past year and a half, longer-dated notes have offered lower yields than shorter-duration bills, creating a “conundrum”, as Alan Greenspan, then chairman of the Federal Reserve, put it in 2005.
But yields on US, European and Japanese government bonds have been climbing for a month, fuelled by strong economic data and, in places, fear of inflation.
Government bond yields soared on Thursday in the eurozone and the UK, pushing the 10-year Bund yield to a four and half year high and the 10-year gilt yield to its highest for nine years.
The moves come a day after the European Central Bank raised its main interest rate to 4 per cent, its highest level since September 2001. Many investors fear the ECB will continue raising rates this year to counter inflationary pressures. The Bank of England on Thursday kept its main interest rate on hold at 5.5 per cent, amid investor worries that rates could rise next month or in August. Predictions of a Fed rate cut have largely been abandoned.
The sharp rise in the US 10-year bond yield was particularly disturbing to technical analysts who monitor the pattern of Treasury interest rates, which have been broadly on the decline since the late 1980s. Over this period, each peak in rates has been progressively lower. Thursday’s advance created a higher peak, breaking the trend and potentially signalling a longer-term advance in rates.
“A lot of people are scared of that 20-year trend line and rightfully so,” said Gerald Lucas, senior investment adviser at Deutsche Bank. “A close above that level at the end of this week would likely target a further rise to 5.25 per cent.”
The 10-year Treasury is widely used to hedge risk associated with fixed income securities such as mortgages.
Bloomberg, in “Asian Currencies Slide as Investors Exit Emerging-Market Assets,” reports that emerging markets currencies are being sold as investors decide to reduce portfolio risks:
Indonesia’s rupiah led declines in Asian currencies on speculation losses in global equity markets will encourage investors to sell riskier assets.
The rupiah fell the most since May 2006 and the Philippine peso had the biggest slide in almost six months as the Morgan Stanley Capital International Asia-Pacific Index of stocks followed U.S. and European markets lower. Concern world interest rates will rise and slow consumer spending and investment spurred the sell-off in emerging-market assets.
“There’s a fair amount of risk reduction,” said Chia Woon Khien, a Singapore-based bond and currency strategist at Barclays Capital Plc. “Some markets like Indonesia where’s there’s been a good rally, are especially vulnerable.”
The rupiah weakened 1.6 percent to 9,025 against the dollar as of 11 a.m. in Jakarta, taking the weekly loss to 2.2 percent, the biggest since the five-day period ended May 19, 2006, according to data compiled by Bloomberg. The peso dropped 0.7 percent to 46.325, according to Tullett Prebon Plc, the world’s second-largest inter-dealer broker.
The Jakarta Composite index of stocks fell as much as 1.8 percent and the Philippine Stock Exchange Index 1.7 percent. The Morgan Stanley Capital International Asia-Pacific Index declined 1.5 percent, the most since April 19. The Dow Jones Industrial Average had its largest drop since April 13.
Drop is Temporary
“A sharp drop in U.S. stocks raises concern investors will shun emerging-market assets, leading speculators to sell the rupiah,” said Masahiro Gao, assistant vice president of the treasury unit at PT Bank Mizuho Indonesia in Jakarta. “At the moment it’s just concern. The rupiah will see bigger depreciation pressure should this continue.” The currency may fall close to 9,200 next week, he said.
The rupiah’s fall is temporary and the currency will rise again, said Bank Indonesia’s Deputy Governor Aslim Tadjuddin. Economic fundamentals remain solid and the central bank will step into the market if necessary, he said.
The Malaysian ringgit slumped to the weakest in two months on speculation funds will flow out as investors repatriate earnings from bond and stock sales. The Kuala Lumpur Composite index of shares fell for a second day, taking losses for the week to 0.5 percent.
Demand for Malaysia’s currency also waned after government reports this week showed exports and industrial production grew less than expected. The ringgit headed for the biggest weekly decline since the central bank scrapped a currency peg to the U.S. dollar in July 2005.
“The ringgit weakness is due to foreigners selling out of the stock and bond markets,” said Lee Cheng Hooi, a technical analyst at MIMB Investment Bank Bhd. in Kuala Lumpur. “The dollar is headed for stronger levels.” The ringgit may weaken to 3.48 in two weeks, Lee said.