Bond markets got choppy at the end of April, when institutional investors began lining up to bet against the market. Since then the situation has gotten worse for bond holders, as spiking yields in Germany, and even US Treasuries, have created a rush for the exit that some fear could turn into a stampede.
Volatility seems to be the new normal for bond markets after a long period of relative calm, and the trend will persist through the Fed’s expected interest rate hike in late 2015/early 2016. On Thursday the 10-year German bund yield reached 2015 highs of 0.995 percent, having languished as low as 0.049 percent just two months ago. It settled back down to 0.84 percent by end-of-trading on Friday.
Spiking yields are sending bond prices lower as holdings from an era of near-zero interest rates begin to lose their appeal. In a reversal of the usual order of things, the German bond market seems to be setting the tone for markets in the US and UK. Treasury yields were spiking alongside the German bund early Thursday, and the 10-year US Treasury yield closed at around 2.4 percent Friday – it’s highest since October of last year.
The reason behind the sudden volatility has divided market watchers. One possible explanation is that euro zone inflation came in at 0.3% for May, up from 0% in April. This suggests stubborn inflationary pressures that, even with low energy prices, will preclude the wave of global deflation that some traders have been betting on. If inflation is back, it doesn’t make sense to hold government debt with borderline negative yields.
Some analysts believe that the bond rout is simply a correction to where yields should be. Persistently low interest rates and Mario Draghi’s advice that traders ‘get used to higher volatility’ are fueling a correction led by market-driven forces rather than the hand of central bankers, and some of us may have forgotten what that’s actually like.
Brian Edmonds of Cantor Fitzgerald LP had the following to say about the bottom falling out of the bond market: “All you had to was look all around the globe to see all the debt that’s accumulated over the past few years, and we’re finally maybe facing that, in that we’re seeing rates rise for no clearly apparent reason.”
It appears that bond market volatility won’t be spilling over into equities for now. And unless yields continue their upward trend in the days and weeks to come, there’s no cause for panic. After all, sovereign debt has historically traded at these levels. It was the post-crisis wave of central bank bond-buying that juiced credit markets around the world.
The normalization of debt markets should not be weighed just on whether or not it will end the S&P 500’s epic bull run. The fact that government debt is once again carrying a cost – that is the more important consideration for the long-term health of the global economy.
Governments around the world have added to their debt burden since 2007 to the tune of $57 trillion, or a debt-to-GDP ratio increase of 17 percent. Much of it came in the form of bailout programs and economic stimulus that won’t do much to boost future growth potential. Servicing this debt will act as a drag on government finances going forward, risking a vicious cycle of flagging infrastructure investment and a tepid global recovery (precisely what we’re already seeing).
It has become apparent that the global economy runs on debt. China, for example, is regarded as a success story for weathering the storm of the financial crisis, but it did so at a cost of quadrupling its total debt. That the debt taps could run dry is a worrying possibility for heavily indebted advanced economies around the world.
Another interesting takeaway is the stark illiquidity of bond markets. The price fluctuations we’ve seen in German and US bond markets aren’t supposed to be statistically possible. The 0.4 percent swing in US Treasuries back on October 15th was an event that was supposed to occur once every 3 billion years or so according to JP Morgan’s Jamie Dimon.
That bond prices in two of the most stable advanced economies can fluctuate so dramatically does not bode well for the next crisis.
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