Uh oh. Are the bond vigilantes trying to make a comeback? If so, it could be more bad news for growth and momentum stocks. And worse — it could mean the multiyear bull market in bonds is in trouble.
The culprit? Inflation. Market-based measures of inflation expectations are ticking up. That’s for two reasons. One, huge quantities of fiscal stimulus seem to finally be making their way into the real economy, driving prices up (copper and oil especially). Second, markets are anticipating a rip-roaring economic rebound in the coming months, as vaccination levels increase in the US and Europe and economies ‘open up’.
We’ll see about that. I note that New Zealand has gone into a ‘snap’ lockdown again. This was always going to be the risk in trying to ‘eradicate’ the virus through a total shutdown: it made you immensely vulnerable (with no natural immunity built up) to the slightest increase in cases.
Source: Federal Reserve Bank of St Louis
But back to the markets. Check out the chart above. The five-year breakeven inflation rate has made a 10-year high. The rate is the difference between inflation adjusted US Treasury yields (TIPS) and normal Treasury bonds. A year ago, as the world plunged into the pandemic, so did inflation expectations. And now?
Trillions in central bank stimulus later — and on the verge of another stimulus cheque being seeing to millions of Americans — market-based inflation expectations are on a tear. And last week, so were bond yields. At one point, the 10-year Treasury yield hit 1.61%. For comparison, the 10-year yield was 0.51% in August of last year.
If you’re scoring at home, that’s a big increase in yields. And when it happens quickly and in a disorderlya way, as it did last week, it causes trouble all over the world. Bond prices aren’t supposed to be that volatile. Entire ‘risk parity’ strategies (with billions of dollars in assets under management) are based on the idea that because bonds (especially government bonds) are less volatile, it is safe to own more of them.
Generally, that’s been true. But in an era of record-low yields and growing government debt, it may not be as true anymore. Last week’s market action showed that when bond yields rise — even if it’s partly in anticipation of an economic recovery and earnings growth — it has a negative effect on richly priced growth and momentum stocks (hence the Nasdaq’s 4% plunge on Thursday).
Things had settled down a bit by Friday. But once the inflation genie is out of the bottle, it’s awfully hard to get it back in there. The Reserve Bank of Australia is leading the way in yield curve control. That’s the preferred method of central banks to ‘correct’ the bond market and keep the price of government borrowing low.
Keep in mind it’s not just the price of government borrowing. The 10-year US Treasury Note is arguably the most important price in the world. From that rate, many other borrowing costs are derived. If bond yields go up quickly (and bond prices down quickly) it raises the cost of borrowing throughout the entire financial system. And when there’s already so much leverage in the system, even minute rises can be disruptive.
An auction of seven-year Treasury notes was described as ‘brutal’ last week. The US government put $62 billion of bonds up for sale. The Primary Dealers — banks who are obliged to buy some of those bonds — too up 40% of the sale. The bid-to-cover ratio of 2.04 was the lowest since 2009. Demand for the notes was also described as ‘anemic’.
But then, who would want to own fixed income investments just as the fires of inflation started to heat up? That’s the question now. Will governments be able to borrow at a low interest rate to try and ‘stimulate’ more growth? Or have they already borrowed too much?
Central banks are confident that ‘more policy’ can keep inflation under control. In fact, they keep telling us they want MORE inflation. And that they wish inflation would be higher. Obviously, they’re not looking for inflation in the two places where it’s most apparent: house prices and stock prices.
But this is always the way with ‘policy makers’. They never see it coming until it smacks them right in the face. Pow! Right in the kisser.
Last week’s events put higher interest rates back on the table. In fact, I showed in the latest issue of The Bonner-Denning Letter why the Fed might be forced to raise rates sooner than you think. They’re caught in a trap of their own making. And they’re not being helped by new US Treasury Secretary Janet Yellen. Paid-up readers can look for that report out later this week.
In the meantime, the Reserve Banks of Australia and New Zealand find themselves on the frontlines of trying to hold back rising yields and fight higher inflation. The scary thing? If the market regains control of price discovery — if interest rates can’t be controlled by central banks — then we will all find out very quickly whether government debt is safe and whether stocks are overvalued.
Editor, The Rum Rebellion
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