I know we are in the midst of a classic pattern, but it is still mystifying to watch it operate. At the end of a cycle, bonds start to decline in price before the equity market starts to fall. One would think that this sequence was sufficiently well established that the time lag between the two events would have compressed (in the stone ages of my youth, the gap was usually four months).
One can expect a bit of a lapse simply because equity investors need to be convinced that a bear market in bonds is real, and not a short-lived phenomenon. But what we are seeing now isn’t healthy skepticism but flat-out denial.
The New York Times gives us some excellent examples. Consider this entry Friday in Floyd Norris’s blog, “Inflation Soars – But Wall Street Ignores It“:
Wall Street is relieved that inflation is under control. Consumers know it isn’t.
Share prices are soaring today, on the good news that the core consumer price index was up just 0.1 percent in May. Economists are ignoring the fact that the overall C.P.I was up 0.7 percent.
The core figure leaves out food and energy, and since that is the rate the Federal Reserve watches, traders think there is little risk of a Fed move to tighten. The theory is that food and energy numbers can be volatile and thus misleading.
The trouble with only watching the core rate is that real people eat and also use energy. And changes in those prices are important over long periods of time.
Over the past three months, the total consumer price index has risen at a high annual rate of 7 percent, while the core rate is advancing at the small rate of 1.6 percent.
To be sure, three months is a short period. But four years is not. Over that period, the overall CPI is up at an annual rate of 3.15 percent, a full percentage point more than the core rate. Food is up at a 3.1 percent rate, a 13 year high for that measure. And energy costs have risen at a 12.9 percent annual rate.
The last four-year period that saw consumer prices rise as much as they did over the last 48 months was in the period ending in August 1994. If Wall Street paid attention to the real inflation figure, the moaning would be intense.
The University of Michigan survey of inflation expectations also came out today. The median forecast is for a 3.5 percent inflation rate over the next year. The average forecast is even higher, at 4.1 percent. “Clearly,” said Robert Barbera, the chief economist of ITG, “people who are polled by the University of Michigan think they have to buy food and gasoline.”
The Times’ Sunday Business section featured an article on housing that attempted to be reassuring, “When Does a Housing Slump Become a Bust?” The caption to a picture of a house on sale, with a “Price Reduced” sign said:
Declines in home prices today are hard to miss, but the average price of a home fell more sharply during the Depression.
Gee, guess I have to uncork the Champagne.
Another article told us the break in the bond market was no biggie, just a revision of overly optimistic prices to a realistic level:
But for the most part, it’s been one big mea culpa. “Those of us in the bond market got it wrong,” says Marilyn Cohen, chief executive of Envision Capital Management, a fixed-income manager in Los Angeles. At the start of the year, bond investors were buying Treasuries on the theory that the slowdown in the housing market would seriously hurt the broader economy…
This would indicate that “the bond market got a little ahead of itself” in anticipating the need for a quick rate cut by the Federal Reserve, said Christopher T. Vincent, head of the fixed-income group at William Blair & Company, the asset manager based in Chicago.
With all due respect, where does the Times find these people? Envision clearly is a small shop focused on retail investors; William Blair, one of the last regional brokerage firms still standing, is a well regarded firm, but known almost entirely for equities. It’s almost certain that its fixed income clients are retail, with perhaps some small college endownments or small foundation. In other words, these upbeat sources are on the periphery of the bond markets.
Contrast this reassuring talk with the sober message in the Financial Times from Michael Mackenzie and John Authers “A fright in the bond markets may end the cheap funds era.” The article concludes that the Times’ preferred explanation for the bond market rout – that they were expecting a rate cut that isn’t happening – is the kindest theory, and even it implies further bond price declines:
This month’s sell-off in the bond markets is already a landmark event. The fall in bond prices, both in the US and Europe, has been as sharp as any seen this decade. The consequent rise in yields has forced investors to re-examine the cosy assumptions that have underpinned the cheap financing available across the world for the past few years.
Now the question is how great the impact will be. US Treasury bond yields in effect set the “risk-free” rate used when pricing securities – from corporate credit through derivative contracts to equities – across the world. They form the financial world’s clearest expression of risk.
Albert Edwards, Dresdner Kleinwort’s well-known global equity strategist, declares: “This is the big one.” Describing the interest rates set by the bond market as the “cornerstone” for valuing equities and other securities, he cautions that if the bond market has truly entered a new era of steadily rising long-term rates, “all investment portfolios will be shredded to ribbons”.
What, then, generated the agitation and what is the outlook? In a market that had been jumpy for some weeks, traders took alarm on June 7 when the yield on the 10-year US Treasury bond moved above 5.05 per cent. The reason: that broke a steady downward trend in bond yields that had persisted since 1987.
Amid repeated economic cycles, bond yields had peaked at progressively lower points – reflecting steadily growing optimism that inflation had been squeezed out of the world system for good. Breaching the trend implied, in the eyes of traders, that the assumption of continuously falling inflation must be abandoned.
Thus the market entered a free fall that took it past further important landmarks. Once 10-year yields passed 5.25 per cent, 10-year rates were higher than the Fed funds rate, which the Federal Reserve charges to banks for overnight loans.
This ended almost a year when these bond rates had been lower. Normally, short-term rates are below long-term ones, as investors demand a higher return for taking the bigger risk of lending for longer periods.
The 10-year yield also reached its highest level since 2002. (It rebounded a little on Friday and ended last week at 5.15 per cent.) Even as the Fed repeatedly raised overnight rates, from 1 per cent in 2004 all the way to 5.25 per cent, longer bond yields had barely moved. Alan Greenspan, former Fed chairman, dubbed the failure of long-term rates to react as a “conundrum”. That conundrum may now be over.
Low long-term bond rates coexisted with cheap financing to fuel a boom in US housing and enabled private equity firms to make ever more ambitious buy-outs. With money easy to come by, there were fewer forced sales of assets – hence price volatility declined. That kept bond yields well behaved and lulled investors to believe the era of low-cost financing would continue indefinitely. In turn, it became cheap to insure against volatility through derivatives, which have boomed.
The sudden sell-off calls the longevity of this era of cheap money and low volatility into question. “With global liquidity becoming less abundant (witness rising interest rates and bond yields), one consequence could be a rise in volatility,” says Paul Jackson of Société Générale in London, who points to a steady increase in the cost of insuring against volatility through equity options. “Equity markets may go up but the ride will be more bumpy and options will never be so cheap again (or not in this cycle).”
Stephen Roach, chief economist at Morgan Stanley, sees the bond price retreat as the second act in a three-act “normalisation” that began with central banks’ move to raise rates. Act III, he says, will bring sell-offs in corporate credit and emerging market debt, both of which currently require unusually low spreads in their interest rates over Treasuries to compensate for the extra risk.
“With spreads in both areas still unusually tight, the curtain has yet to go up on this final act,” he says. “Moreover, to the extent that higher levels of both short- and long-term real rates begin to take a toll on expectations of real economic activity, expected default rates on domestic credits should rise.”
It is hard, though, to explain why bonds started to fall – especially as this sell-off does not look much like either of its most recent predecessors, in 1994 and 2003.
In 1994, a bear market in bonds was sparked when the Fed began raising rates from 3 per cent with a quarter-point boost in February. Within a year, the Fed funds rate had doubled to 6 per cent. Traders quickly formed a view that the Fed had kept rates too low and that inflation was set to accelerate. The yield on the 10-year bond rose to a peak above 8 per cent in November 1994, from 5.74 per cent in January.
That meant severe losses for bond investors, while the ripples brought a series of crises throughout the world’s riskier markets, starting with Mexico. But developed markets emerged unscathed. Bond yields went up but, unlike the sell-off of this month, they kept within the long-running downward trend. US stocks were flat in 1994 and then went on to stage their biggest rally since the 1920s.
But today’s sell-off is not an inflation scare like that of 1994. Traders gauge expectations for inflation through an analysis of inflation-protected Treasury bonds – and these have not reflected a pronounced fear of rising prices. Prices there imply a US inflation rate of 2.45 per cent over the next 10 years, up from a projected 2.35 per cent a month ago but well below last year’s peak of around 2.75 per cent. This cannot explain the spike in bond yields.
The more recent sell-off in 2003 came when, after two years of successive rate cuts, the Fed held rates steady. The selling was triggered by holders of mortgage portfolios, who had expected further cuts and were caught off guard. Nothing similar seems to have happened this time. While there has been some selling by mortgage investors, they have been better prepared for a jump in yields.
“Our sense is that this time the mortgage community has been pretty well hedged and mortgage prices have moved in sync with what the models have predicted,” says Dominic Konstam, head of rate strategy at Credit Suisse. “It’s hard to make the case that mortgage investors have been driving the sell-off.”
So what does explain what has happened? Colin Lundgren, head of institutional fixed-income at RiverSource Institutional Advisors, says: “It has been a culmination of factors: stronger data on the economy, the removal of rate cut expectations and the absence of Asian buying.”
The best single explanation may be that the bond market suddenly recognised it had grown too complacent about risk. “There is a very good reason why yield curves are upward sloping,” says Mark Kiesel, portfolio manager at the Los Angeles-based Pimco, one of the world’s largest bond fund managers, which was one of many investors to start selling long-dated bonds. “An investor should receive a higher yield to compensate for the greater risk of owning a fixed-rate bond over a period of time.”
A change in expectations about the Fed also played a role. Three months ago, interest rate futures priced the expectation of a decline of 60 basis points in the Fed funds rate by the end of the year. Thus the market assumed two interest rate cuts from the Fed were a certainty. This outlook has now been jettisoned. Futures markets even imply a small risk of a rate rise.
“Rate cuts were baked in the cake and we had to reach into the cake and pull them out,” says Mr Lundgren.
For investors in long-term bonds, yields well below the 5.25 per cent Fed funds rate suddenly began to look very risky. “Treasuries were not competitive versus equities and other assets – and owning long-dated bonds entails a lot of interest rate risk,” says Mr Kiesel. “With a funds rate at 5.25 per cent, investors were better off putting their money in cash.”
The problem is that leaving the “conundrum” world – in which long-term interest rates rates do not rise – implies that bond prices have much further to go down and yields further to go up. Alan Ruskin, strategist at RBS Greenwich Capital, says that 10-year yields have over history been about 0.8 percentage points higher than the Fed funds rate. That would mean 10-year yields of above 6 per cent – a further rise of more than three-quarters of a point – even if the Fed does nothing.
Other explanations generate more concern. Mr Greenspan’s own explanation for his conundrum was a “savings glut”. China and other Asian economies were generating excess savings, and parking them in US bonds. What if they should sell? “Less Asian sponsorship of Treasuries is a cloud hanging over bonds,” says Mr Lundgren.
The latest official data from the US Treasury, covering April, show that Asian buyers indeed stopped buying long bonds and bought equities and corporate bonds instead. Traders have noticed that throughout the ast two weeks, bond prices fell during Asian trading hours.
“US-based traders were coming in every morning to see that the market had traded very badly overnight,” says Mr Konstam. “The lack of buying in overnight trade created a frenzy of selling among the London and Asian-based crowd.”
Another fear is inflation. Evidence of increasing price pressures could send rates much higher – although the latest US data, published as the market was beginning to calm down at the end of last week, is ambivalent, with “core” prices, excluding fuel, still looking under control. Any clear sign of returning inflation could take yields much higher over the summer.
Another imponderable is home loans, which are priced off Treasury yields. With variable-rate mortgages growing more popular among Americans, this bond sell-off could feed through into the housing market more swiftly than its predecessors. More than $1,000bn (£506bn, €747bn) in adjustable-rate mortgages expires in the next year.
“There is already a problem with housing and it has become less affordable as the 30-year mortgage rate has risen to 6.7 per cent in the past month,” says Mr Kiesel of Pimco. “The jump in rates means the cost of a mortgage has risen more than 8 per cent.”
Optimists suggest that the housing market will naturally put a lid on interest rates: the Fed cannot raise rates and risk a full-scale crash in home prices, they say. If rising yields tighten conditions for mortgage borrowers, the response may even be rate cuts.
The more fearful view is that the contradictions in the US economy are about to come home to roost, as the housing boom required unsustainably cheap finance. On this reading, yields of 5.15 per cent, though low by historic standards, could provoke an economic crash.
Just as the bond market suddenly snapped out of years of complacency without a specific trigger, so the holders of many riskier assets may yet do the same thing, if such fears intensify. Whether investors in risky assets are “remarkably resilient or remarkably complacent”, says Mr Lundgren, “if bond yields rise further, the herd may start to run”.
As the always observant Barry Ritholtz tells us, none of this counts, at least for now:
Of course, none of this should matter to traders. The momentum remains strong, and the overall psychology still disbelieves the market. In fact, a few recent sentiment measures are so bearish that its all but impossible for a top to form here. (I’ll go into some details on this later).
The melt up to Dow 14,000 continues . .