Cast a gaze across global bond markets and it’s a sea of calm. Yields are close to record lows, volatility is nowhere to be seen and central banks are still ploughing trillions of dollars into the economy to help foster a recovery.
But even in this new post-pandemic world, investors risk getting caught wrong footed. The International Monetary Fund’s chief economist Gita Gopinath warned last week of stretched asset valuations, saying investors are pricing in the best-case scenario when it comes to the trajectory of the coronavirus crisis. And any hint from authorities that monetary policy may not remain as easy, could spur turmoil across markets. Just look at how fast yields have moved higher in recent weeks on even the whiff of inflation.
From the US taper tantrum in 2013, to the VAR-shock in Japan a little under two decades ago, here’s a glance at some of the blips in the multi-decade bull market in bonds, and what it might mean for the future.
As always, the number one danger is inflation, which erodes the value of debt as it accelerates. That’s especially true today, since duration — a measure of how sensitive a bond is to rising interest rates — is near record highs in corporate debt markets. In Europe, governments have been ramping up sales of longer-dated bonds, the most exposed to a pick up in consumer prices.
What’s more, over $16 trillion of debt now yields less than 0%, leaving holders with little wiggle room if the outlook shifts. For Alessandro Tentori, chief investment officer at Axa Investment Managers, that’s adding to an already-explosive cocktail of risks that plague the market, including a dearth of liquidity after years of hefty central-bank bond buying.
It could also force central banks to scale back their debt purchases and raise rates faster than many investors expect, driving down the value of bonds even further. Axa has cut back its debt holdings, particularly in Treasuries, where the 10-year yield could rise to as high as 3%, according Tentori, a level last seen in 2018. It was trading around 1.19% on Friday.
“It’s a double whammy,” he said. “It might be painful, because expectations would be self-reinforcing.” Money markets are currently betting the Federal Reserve won’t raise until late 2023.
And since safe and liquid assets like German bunds or Treasuries would not be immune from accelerating inflation, a selloff could wreak havoc on even the most conservative portfolios. In March, as the rout spurred by the coronavirus pandemic deepened, investors started selling their high-quality bond holdings in order to meet margin calls.
In the U.S., five-year, five-year inflation swaps, a gauge of price rises over the next decade is at 2.40%, near the highest level since 2018. In Europe it has climbed to 1.35%, though that’s still well below the European Central Bank’s close-to 2% goal.
Another big risk right is if markets abruptly wind back their expectations of how much debt central banks will keep hoovering onto their balance sheets. So-called “taper tantrums” over the past decade have rocked markets on both sides of the Atlantic.
The trigger could be improving economic data as more vaccines are rolled out, allowing countries to reopen their economies, according to Peter Chatwell, head of multi-asset strategy at Mizuho International Plc.
“The growth impulse next quarter will be very difficult for bond markets and monetary policy makers to deal with,” Chatwell said. “Their macroeconomic models will be suggesting they should be significantly more hawkish, and the bond market will be pricing this, but their focus on financial conditions will consequently be deteriorating.”
What Bloomberg Intelligence says
“Rates volatility is subdued but there are some movements going on underneath the surface. Taper seems far away and lessons will have been learned from prior tantrums. The asymmetric risk is prompting exposure to reflation regardless if it’s not the base-case.”
— Tanvir Sandhu, chief global derivatives strategist
Markets have already been gradually repricing. The yield difference between five-year and 30-year U.S. Treasuries is around 20 basis points wider than at the start of the year. Yet, that pales in comparison to 2013 when then Federal Reserve Chairman Ben Bernanke revealed plans to taper the central bank’s bond buying program. U.S. 10-year yields almost doubled to 3% in the four months to September.
In Germany in 2015, a weak bond auction proved to be the catalyst. Bets on lower bond yields were so overcrowded, that 10-year yields rocketed one percentage point from just above 0% in just two months. This time around, the kindle could be China overtightening policy like in 2010, according to Morgan Stanley.
Taper tantrums are an example of what investors call a “value-at-risk” or VAR shock. VAR measures how much risk there is of losing money given normal market conditions and has been responsible for some of the largest bond-market shakedowns this millennium.
That’s because during periods of exceptional calm, the measure doesn’t tend to flash any warning signs. As a result, positions get crowded, and when a trigger finally goes off everyone rushes for the exit at the same time.
The first such VAR shock occurred in Japanese government bonds in 2003, when domestic banks bought so much debt that they exceeded their risk limits. As yields started rising, they were forced to off-load their holdings, creating a self fulfilling cycle that pushed the 10-year benchmark rate almost one percentage point higher over the course of three weeks.
A similar event happened in Germany in 2019. Investors who piled into bonds before the ECB announced a deposit rate cut and resumed its bond buying program, scrambled to cut their losses as benchmark yields rose 60 basis points in the subsequent four months.
Today, despite the recent pullback in U.S. Treasuries, a gauge of the market’s volatility has held near the lowest level on record. And of course, any sign that the positive global expectations for this year will be derailed by new virus mutations or a hiccup in the vaccine supply, could see investors pour back into bonds, especially if they begin to bet on another round of easing from central banks.
“The problem with these VAR shocks or sudden stops or flash crashes is that by their nature they are not predictable,” said Christoph Rieger, head of fixed-rate strategy at Commerzbank AG. “We haven’t had one in a while and the low volatility goldilocks environment amid huge debt build-up and central-bank distorted markets certainly warrant caution.”
- Germany, France and Spain are expected to sell bonds totaling over 19 billion euros ($23 billion), according to Commerzbank AG. Italy may sell 50-year debt through banks
- There are no redemptions until Feb. 25, when France is due to pay around 17 billion euros; Germany, Portugal, Ireland and Austria pay about 3 billion euros of coupons next week
- The U.K. will hold three regular gilt auctions, selling a combined 7 billion pounds and buying back 4.4 billion pounds of debt across three operations
- Data releases include preliminary manufacturing and services PMI for February for the euro area, Germany and the U.K. as well as France, all on Friday
- Germany also publishes the ZEW survey for February on Tuesday
- The U.K. data slate is busy with January inflation numbers on Wednesday and retail sales, government borrowing figures on Friday
- Investors will seek to glean fresh clues on inflation from ECB’s Isabel Schnabel when she speaks on Thursday, after she previously downplayed the rise in German inflation
- BOE’s David Ramsden and Michael Saunders speak on Wednesday and Thursday respectively, and will be watched for possible views on expectations for the direction of interest rates
- There are no major sovereign rating reviews scheduled on Friday