That the secular bull market in bonds is getting long in the tooth is well understood, but whether post-Brexit lows in bond rates have signalled the end to the rise is yet to be confirmed.
However, investors may have seen another small confirmation the multi-generational rally is behind them with news overnight that the ECB is considering the tapering of its bond-buying program as it nears the scheduled end to quantitative easing.
Bloomberg reported that sources who asked “not to be identified because their deliberations are confidential” said the ECB was nearing a consensus on tapering.
[For clarity, a tapering is simply a gradual reduction in the level of buying – in this case by $10 billion Euro a month – as the ECB reduces its purchases from $80 billion back to zero to avoid an abrupt halt.]
To my eye, after years in markets, this feels very much like a kite-flying exercise to gauge market reaction. That’s doubly so given the the ECB told Bloomberg via email that “the Governing Council has not discussed these topics”, and thus didn’t dismiss the idea out of hand.
That makes absolute sense given tapering is a procedural matter to avoid an abrupt halt to QE and must come at some point, unless the ECB really is running an open-ended quantitative easing program.
But what’s most important about this ECB chatter, no matter how long it takes to come to reality, is that it is another subtle shift in what appears to be a move away from monetary policy as the only tool of economic stimulus, and a recognition that negative rates and flat bond curves hurt banks.
In its latest world economic outlook, the IMF warned that monetary policy was not working and could not lift growth on its own.
“Several emerging market and developing economies still face daunting policy challenges in adjusting to weaker commodity prices. These worrisome prospects make the need for a broad-based policy response to raise growth and manage vulnerabilities more urgent than ever,” the IMF said.
That’s a clear shout out that monetary policy is at an end and fiscal policy needs to fill the void.
Bonds are vulnerable to a big selloff
Nikko Asset Management recently warned that bonds are not a safe haven and that “bond yields “are at such low levels that the risk-return profile is asymmetric”.
That’s something Wall Street’s “bond god” Jeff Gundlach picked up on talking to a crowd of investors at the Grant’s Interest Rates Observer conference in New York City on Tuesday.
“How in the world could we be talking about rates never going up when in fact rates have bottomed?” he said, adding that “in the investment world when you hear ‘never’,” (as in rates are ‘never going up’), “it’s probably about to happen”.
Like the IMF, Gundlach says now is the time to pivot toward fiscal stimulus.
What’s potentially devastating for bonds from a move toward stimulus, according to PIMCO’s Joachim Fels and Andrew Balls, is that “it could shake up the newfound consensus that we are in secular stagnation, that central banks are the only game in town, and that therefore rates will remain low forever”.
Bond rates matter for stocks.
Where bond rates go is important for the valuation of other assets, especially stocks. So if rates rise that could put downward pressure on stocks prices in the US and across the globe.
That’s especially the case given stock valuations relative to historical price to earnings ratios.
In its June Monetary Policy Statement, the US Federal Reserve highlighted that with stretched PE ratios, bond valuations were important.
It said (our emphasis):
Forward price-to-earnings ratios for equities have increased to a level well above their median of the past three decades. Although equity valuations do not appear to be rich relative to Treasury yields, equity prices are vulnerable to rises in term premiums to more normal levels, especially if a reversion was not motivated by positive news about economic growth.
Which is where this latest rise in yields is so important. Rates aren’t rising because growth is picking up. Rather, bond rates are rising in anticipation of a shift in monetary policy globally and a change in the term premium.
Which is why traders and investors are watching the moves in bond rates across the globe closely and why the shift higher in rates matters.
And the level they are watching especially closely is the short term is the 1.72/1.75% region on US 10-year Treasuries. A break of that level, US 10’s are currently sitting at 1.67%, would suggest a move back towards the 2%, which is where the trendline from the United States own taper tantrum back in 2013/14 when US 10’s rose to 3.03%.
Now, of course, as Warren Buffett said back in May, if low rates persist, stocks will continue to look cheap. But he added that “if interest rates normalise, we’ll look back and say stocks weren’t so cheap”.
That’s the fear the bond market sell-off might just awaken if rates surge higher.
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