Writer market

Bond liquidation is a warning to the Fed

The writer is president of Queens’ College Cambridge and advisor to Allianz and Gramercy

The combination of extremely low and relatively stable US government bond yields has baffled many market watchers for some time now, also challenging traditional economic analyzes.

This has made the rise in yields over the past two weeks particularly noticeable, raising interesting questions for markets, policies and therefore the global economy.

It is customary to characterize benchmark US government bond yields as the most important market indicator in the world. Traditionally, they have signaled expectations for growth and inflation in the world’s most powerful economy. They have served as the basis for pricing in many other markets around the world.

Breaking with a long history, these benchmark measures have been decoupled in recent years from economic developments and prospects. Their long-standing correlations with other financial assets, including stocks, have collapsed.

And their information content has become distorted and less valuable. Coming out of the 2008 global financial crisis, this was attributed to excess global savings which put continued downward pressure on yields.

Over time, however, it became clear that the main driver was the abundant and predictable purchase of government bonds by the world’s most powerful central banks as part of quantitative easing programs, particularly the Reserve. federal government and the European Central Bank.

The power of central banks to intervene in market prices should never be underestimated.

The trillions of dollars in bonds bought by the Fed and the ECB have distorted the usual two-sided markets and encouraged many to buy a whole range of assets far beyond what they normally would on a fundamentals basis.

After all, what could be more reassuring than a central bank with a fully functioning printing press, willing and able to buy assets at non-commercial levels. Such purchases legitimize past private sector investments and provide assurance that there will be buyers willing to buy assets for those who need to sell to reposition portfolios.

This is a device that encourages the private sector to “anticipate” central bank purchases at prices traditionally considered unattractive. No wonder even those who are convinced of a fundamental valuation error have been reluctant to switch to the other side of a bond market dominated by central banks.

While these factors remain in play, yields have slowly but steadily increased over the past two weeks, from 1.30% for the 10-year bond to 1.50%.

With global growth prospects dampening somewhat due to the Delta variant of Covid-19, the drivers have been a mixture of mounting inflationary pressures and mounting signs that central banks will struggle to sustain the era of ” Infinite QE ”- meaning infinitely ultra loose financial conditions. Signs in recent days have included statements from the Bank of England and higher rates in Norway, adding to moves in some developing countries.

The more interest rate volatility increases, the greater the risk of an upward gap in yields, given that we are starting from a combination of very low yields and extremely one-sided market positioning. The larger the gap, the greater the threat to market functioning and financial stability, and the greater the risk of stagflation – the combination of rising inflation and low economic growth.

Like a bullet submerged deep in water, a combination of market crash and political error could result in an increase in returns that would be difficult for many to manage.

Importantly, this does not mean that central banks, and the Fed in particular, should delay what should have already started – that is, embark on reducing what, oddly enough, is the same level of monthly asset purchases ($ 120 billion) than at the height of the Covid-19 emergency 18 months ago.

On the contrary, the longer the Fed waits, the more markets will question its understanding of ongoing inflationary pressures, and the greater the risk of disorderly market adjustments undermining a recovery that must be strong, inclusive and sustainable.

For their part, investors should recognize that the enormous beneficial impact on asset prices of a prolonged clampdown on central bank returns comes with a consequent possibility of collateral damage and unintended consequences. Indeed, they only have to see how difficult it has become to find the kind of reliable diversifiers that help underpin the old portfolio mix of return potential and risk mitigation.

Not covered – Markets, finance and strong opinion

Robert Armstrong dissects the most important market trends and explains how the best minds on Wall Street are reacting to them. Sign up here to receive the newsletter directly to your inbox every day of the week

Tags : wall street
Margarita W. Wilson

The author Margarita W. Wilson