What is the difference between 1.6 per cent and 2.2 per cent? Either: not much, or a potentially explosive shift in the way global investors view the world that presages turbulent market conditions ahead.
Yields on US government debt, which move inversely to prices, have surged during May and peaked this week, leaving holders nursing their worst monthly loss since December 2010. Ten-year Treasury yields hit 2.23 per cent on Wednesday, up from 1.61 per cent at the start of May, and were back to 2.20 per cent in volatile Friday trading.
The immediate cause was concern that the Federal Reserve would soon start to “taper” its open-ended bond purchases – with far-reaching consequences for US debt markets and perhaps signalling a turning point in the 30-year Treasury bull market.
As investors awoke to the realisation that extraordinary monetary stimulus through “quantitative easing” cannot last for ever, repercussions were felt worldwide. Emerging economies’ bond markets also saw yields jump sharply, as did Japan, where the equity market went into a tizzy. At one point the Nikkei 225 index was down 15 per cent from last week’s peak.
Unsettling investors were worries that the central bank “put” led by the US Fed that has driven asset prices sharply higher over the past year – beyond levels justified by economic fundamentals – was unwinding. “I can’t say where, but there will be unexploded bombs going off as yields start to rise,” says Kevin Gaynor, global head of asset allocation at Nomura.
Confidence remains high that central bankers will continue to support economies – and act as the bomb disposal squad when needed. Even the US has yet to see a self-sustaining recovery while “the Bank of Japan has its work cut out”, argues Mike Amey, head of sterling portfolios at Pimco. “We think that the bull market is over, but we don’t believe the secular bear market has started.”
The stresses in markets, however, highlighted their vulnerability to any hint of a shift in Fed support. Central bank action over the past four years has compelled investors to borrow at low overnight rates and pile into higher yielding debt in so-called “carry trades”. Nobody knows the extent of such positioning, but the danger is that investors try to get ahead of any attempt by the Fed to remove the punchbowl.
“There is a risk that, even before the growth issue is clear, the markets move to an extreme as so much leverage and one-sided positions have built up at the Fed’s request over recent years,” says Richard Gilhooly, strategist at TD Securities.
This week’s turmoil “underscores concern about emerging market excesses, which have been the side-effect of very low and stable US Treasury yields”, adds Mr Gaynor. “If they are going up, we should be more worried about things like leveraged financial systems in emerging economies.”
Ripple effects are already clear in US investment grade corporate debt markets, where total returns for the year have fallen back into negative territory. Blue-chip companies have sold debt at record low interest rates, and there is “no way investment grade bonds can escape a violent sell-off in Treasuries”, warns Edward Marrinan, head of US macro credit strategy at RBS Securities.
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However, the impact – so far at least – has been noticeably less pronounced on US equities and junk-rated debt. “If we see stability in Treasury yields, then high-yield bonds can skate through,” says Mr Marrinan. “By virtue of their higher coupons and capital gains, the asset class has greater insulation than investment grade bonds against a back-up in Treasury yields.”
A better performance by equities and high-yield bonds is consistent with the view that Fed tightening would only come when US economic prospects picked up, reducing the default risk of lower-rated companies and increasing earnings prospects. In Europe, the pattern in bond markets has been the opposite, however, with a bigger sell-off recently in high-yield than investment grade markets.
The next big event is the May US jobs data due at the end of next week. “A strong payrolls number would add to investors’ belief that the Fed could pull back on their bond buying,” says Ajay Rajadhyaksha, strategist at Barclays.
Jay Mueller, senior portfolio manager at Wells Capital, adds: “The Fed is in no hurry to change things, but if we get stronger economic numbers, then investors will connect the dots and say we have moved to a higher gear.”
A US economy in higher gear would intensify the upward pressure on bond yields. Mr Rajadhyaksha argues the Fed would want to avoid an unruly sell-off that could imperil the economy’s progress. So credit markets and equities would remain supported.
But still there could be plenty of unexpected eruptions. Didier Saint-Georges, investment committee member at Carmignac, the French fund manager, warns: “As the destiny of financial markets hinges more than ever on central bank action, increased volatility is going to be part of our life for the medium-term future.”