In the latest Fund Managers’ Survey release by Bank of America this week, there was an overarching agreement on what Wall Street’s “smart money” believes will be the biggest drive of equity prices in the next 6 months. The answer, as shown in the chart below, is Treasury Bond Yields…
… and not just any bond yields, but – as per the Fed model which has reigned supreme in recent years – rising bond yields, which suggests that as a result of a rising risk premium, stock prices would slide And in a time when even central bankers are increasingly agitating for a “gentle” increase in long-term rates, we can see why the so-called smart money is concerned that upcoming moves in yields could disrupt the stock market’s bull market. After all, as we reported cautioned last week, even Ray Dalio warned that a yield rise as small as 1% could lead to trillions in MTM losses.
Curiously, even one of the biggest deflationistas, the man who coined the “Ice Age” thesis, SocGen’s Albert Edwards is concerned. As he points out in his latest piece which asks “Has the bull market in government bonds finally ended“, “as government bond yields snap sharply higher, many investors are concerned that the 35-year bond bull market is finally over. All investors, bond and equity alike, have benefited from this stunningly positive investment backdrop. This long bull market has often seen occasional cyclical rises in yields, but some feel this time it’s different. A change in the wind is being felt as governments listen to the central banks’ recent call for fiscal, rather than monetary policy, to do the heavy policy lifting from hereon in. Is the long bull market in bonds now over.”
As he further notes:
“The recent bond sell-off has indeed been savage. Japanese, UK and US 30-year bonds have lost 12%, 11% and 8% respectively since yields bottomed in Q3. But why are investors any more nervous about this bond market sell-off, savage though it has been, than any other selloff over the past 35 years? Japan has been the trailblazer in the long bull market, starting a full decade before the west and we have seen savage cyclical spikes in yields during this time (eg from 0.8% to 2.2% in late 1998, and more recently in late 2010 yields spiked from 0.8% to 1.3%. That did not stop the descent to negative yields, where 10y yields still remain.”
So what, Edwards asks, “makes the current sell-off different? After all, the surge in implied inflation expectations has not been unprecedented, even in the UK (see chart below).”
To be sure, elements of the current selloff have been observed on previous occasions as well: “in both the US and UK the rise in inflation expectations has been driven by surging nominal yields, while real yields have barely budged (see charts below). We note though that at times of extreme market volatility (coming soon in my view), wild swings in real yields can sometimes be observed and investors should be ready to take advantage (eg see spike in US real yields in 2008 as inflation expectations collapsed faster than nominal yields).”
However, this time may be different.
Edwards admits that “I sense that this time around, the current bond sell-off is leading to concerns, not just of a cyclical sell-off but that something more might be in the air. One after another, central banks, supra-national organisations, and now governments themselves (with the UK leading the way) are calling for a decisive shift away from relying on monetary policy and toward greater fiscal stimulus.”
He adds the following:
The reason why bond investors are so worried this time is that they sense a decisive change in the mix of policy in the air. Central banks and the IMF have long been calling for governments to take on the baton of stimulus as they feel they had reached the limits of what monetary policy can do. The Japanese were the first to embrace the change to the mix of policy a few weeks back. Yet the markets were initially disappointed by the Bank of Japan’s 21 September announcement of unchanged QE of Y70tr pa and that interest rates were not pushed further into negative territory. But the announcement that 10y yields would be pinned at 0% was a massive change in policy that has not been fully understood by the markets. Pinning yields at zero basically gives the Japanese government a fiscal blank cheque to spend and borrow as much as it likes and if QE needs to be Y70tr or Y170tr pa to keep yields at zero, so be it. These are wartime measures and indeed the last time we saw something like this was in the US at the end of WW2 when 10y yields were capped at 2½%.
Still, despite some initial volatility across capital markets, the Japanese announcement was largely swept under the rug and stocks promptly rebounded. Edwards the notes that it was “only the UK?s new Prime Minister, Theresa May’s blunt rejection of further QE as benefiting the rich and her promise to allow fiscal policy take the strain – a total repudiation of the previous Tory Governments? approach – that caused investors to sit up and smell the coffee.”
“So the twin prospects of more bond supply and a much reduced appetite for further QE are freaking out bond investors.”
But, for all the rising concern, Edwards end ons a hopeful not, saying that bond investors should not be “freaked out”, as Japan is the template going forward ?”as all pretence at fiscal and monetary policy rectitude will soon be thrown out of the window.”
So instead of rising nominal yields, which may happen if only briefly, Albert Edwards believes that the next big move in yields will be a familiar one: much lower.
In the next recession, I see both more fiscal expansion and more QE. I expect US 10y yields to converge with Japan and European yields at around minus 1% in the next recession.
What recession? I leave you with one worrying chart. The last US GDP update saw the alternative measure of national output, namely Gross Domestic Income (GDI) actually decline 0.2% qoq annualised (vs 1.4% a rise in GDP). GDI is now flat on a six-month basis (see chart below). The pronounced weakness of GDI relative to GDP might be an ominous omen, for it may well be indicating that a US a recession is already underway – just as it was in 2007.
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Or, to summarize much of the above, one of the longest-running “channels” in modern financial history, that of the steady grind lower in long-term yields, will continue to move down and to the right, even if it briefly breaches it to the upside in the coming weeks or months.