Rudi's View | Jul 07 2017
All had been suspiciously quiet, but bond yields are back on the move and share market volatility already has announced itself. What exactly is happening and should equity investors be worried?
-Central bankers have triggered a sudden sell-off in global bonds, with yields rising fast
-Volatility in the Aussie share market has picked up noticeably
-The timing seems odd as global economic momentum seems waning and inflation remains low
-Should investors prepare for a repeat of the reflation trade in 2016?
By Rudi Filapek-Vandyck, Editor FNArena
Traditionally, share market tipsters and commentators seldom pay heed to what is happening in global bond markets.
Rather they prefer to talk about government regulation, the economy and individual company specifics. And cheap/expensive valuations, of course, if not underlying trend lines and key technical support and resistance levels.
All this is changing quite rapidly as times they truly are a-changing and equity investors, whether they like it or not, are now forced to pay attention to what is happening in the world of global IOUs, and why.
Thirty-Six Years Of Falling Bond Yields
The main reason as to why bonds were seldom mentioned prior to last year is because the long term trend for global yields had been down, down, down (as in those ubiquitous Coles supermarkets ads). On occasion, when the subject of conversation moves to banks and the local housing market, you'll hear someone saying things along the lines of "I still remember when interest rates were as high as 18% in Australia" and that pretty much sums it up nicely.
Back in the eighties, interest rates were high, as high as they've ever been in recorded history, and they have since steadily decreased until last year. Falling bond yields are supportive of rising equities. No need to pay attention, thus.
Just how little attention was paid is still illustrated by today's witnesses/survivors of the 1987 global equities crash, also known as "Black Monday". Nearly thirty years after the event, men with grey hair and lots of wrinkles in their faces will tell anyone who cares to listen they'd turn up at work as a young brookie and there it was, a sudden collapse in share markets, all at once, in one pull down, with no warning in advance, and with seemingly no clear trigger (other than bloated valuations).
In reality, of course, all that carnage had become inevitable after the Bundesbank abruptly changed its policy on Friday, triggering a major re-set for global bond markets which then had its consequences for equities on the subsequent Monday. Who knew? Bonds can trigger share market mayhem, just like that.
Former advisor to President Clinton, James Carville, formulated it best when he stated back in 1993:
"I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everyone."
The following year, 1994, became known as "The Great Bond Massacre" when the Federal Reserve failed to properly communicate its intentions and bond markets had a massive hissy fit, simultaneously pulling everything else down into the quagmire.
Pretty much everything one needs to know, as an equity investor, lies embedded in that 30-year history of global bonds. It's why a change in trend for bond yields automatically gives equity markets participants the jitters, and why central bankers do their utmost to communicate well in advance, and then again, and again, and again, and then act gently.
US Ten Year Treasuries: 1871-2017
[graph: Dr David Brown, Monthlyinvestor.co.uk]
The End To A Long Term Trend
Unfortunately, Central Bankers are not really Masters of the Universe, they just pretend they have all the answers and everything under control (goes with the job requirements), in reality they do not. Plus markets do not always play along like central bankers want them to.
Last month, a general sense of frustration among central banks led to a global coordinated message to investors that bond yields, 10-years and beyond included, really had to move higher. The Federal Reserve is the only major central bank that is now "normalising" monetary policy after a near decade of extreme stimulus, but the in total of four hikes thus far only managed to push up short duration bonds. Bonds with a duration of 10 years and beyond had since the start of 2017 been moving into the opposite direction.
The latter makes sense because inflation, both in the USA and most elsewhere across the globe, remains stubbornly low and economic momentum had been mixed at best, missing expectations on most measurements. Let's not forget: policies in the UK, Europe and Japan are still extremely stimulatory, which also weighs upon longer term bond yields.
At the same time, Janet Yellen & Co at the Federal Reserve seem intent to further normalise policy settings, irrespective of data and/or inflation. The problem with such a context is that rising yields on shorter term bonds are merely catching up with falling yields on longer term bonds, creating what bond specialists call a "flattening yield curve". The next step, if both dynamics don't change, would be an inverse curve (short yields higher than long yields). This is negative for lenders (banks) as they make money out of arbitraging short against long via loans to their customers.
If banks stop lending, the economy grinds to a halt and the Federal Reserve is achieving the opposite of its ultimate target, which is sustainable economic growth without super-stimulatory monetary policy. Hence why I used the term "frustration", and why central bankers felt they had to send a clear message to global bond investors.
Boy, did they get the message alright! US bonds had entered June on an ongoing gradual flattening and declining path, but once the message got through, the yield on ten-year bonds quickly lifted from 2.10% to 2.31%. Australian bonds responded in synch, moving from 2.32% to 2.70%.
Looked at it through a short term window (see below), it does look pretty scary.
[Graph National Australia Bank]