All the talk these days is falling bond prices and the possibility that this is the end of the thirty-year secular bull market in bonds. This “turn” has been called many times over the past generation, and each time yields have ultimately fallen further, ultimately to unprecedented, almost Japanese lows. I remember when 5% was the floor, 4% was the floor, etc. Nobody knows anything in this business.
But now respected bond market experts are saying that this is it: rates will start rising from here. Personally, I’m not predicting that, although I do not expect to see rates go any lower, either. I’m looking at very weak numbers: 1.1% inflation, 3.4% nominal growth, and 7.5% unemployment. These do not constitute a strong predicate for rising bond yields. However, many believe that the QE has been artificially propping up bond prices, and that prices will fall as QE tapers off. Others believe that the economy has achieved escape velocity such that we will see a return to normalcy in growth, inflation and bond yields. I don’t see that either--not with the current economic telemetry. (Note: nominal growth of 3.4% has historically been considered recessionary; the economy has been stuck in second gear for the past three years.)
But let’s assume that I am wrong and that this really is the end of the secular bull market (for whatever reason) and bond yields will start to return to more normal levels. If by “more normal levels” we mean precrash yields, that would be around 4-5% for the 10-year, considerably above the current 2.1%. While that may sound modest in yield terms, it is big in price terms. Already, with the mild uptick in yields over the past month, some fixed-income hedge funds are reporting substantial losses.
So, what if we have a panic at some point this summer, and the fall in bond prices accelerates? What would that mean for the stock market? We’ve watched this movie before: when yields spiked in 1987 and 1994. In 1987 the impact on stocks was profound; in 1994 it was less so and quite transitory.
And what about now, in the summer of 2013? The key questions are: (1) how big is the carry trade (borrowing overnight to buy bonds); (2) how levered are the positions; and (3) how deep are the pockets of the most exposed speculators. I don’t know the answer to these questions, but nobody else does either: this is the stuff of rumor and “market intelligence”.
But there is little doubt that a rapid unwind of the carry trade will be at least temporarily bearish for equities, for financial stability and for confidence. Personally, I’m not very worried, but we could have a few bumps if this scenario plays out.
Just as was the case with LTCM in 1998, we do not know the other positions or the interconnectedness of the most exposed institutions. It’s not just which banks or hedge funds are exposed to falling bond prices: it’s what other asset classes they are in, on what scale, and how deep and liquid those markets are. You may recall that when LTCM’s “EMU convergence trade” went awry, the impact wasn’t on the bonds of the governments that were supposed to be converging, but rather on Russian domestic debt and those who owned it. Nobody could have predicted that. When the SIV meltdown occurred in 2007, nobody knew that it would most affect German banks.
When institutions are hit with redemptions or margin calls, they sell their sellable stuff first. So, for example, if a hedge fund is currently under redemption or margin pressure, that selling pressure could appear in a market that is otherwise stable. This explains why stocks have been gyrating as bonds have been falling: some people are being forced to raise cash, or are front-running those who will be forced to raise cash. As prices gyrate, VAR limits, counterparty lines, and advance ratios all decline together, forcing more selling.
We have seen this phenomenon many times, and it is a normal part of market cycles. Such unwindings are usually benign. As long as no major institution is critically wounded, the markets will right themselves, as they did in both 1987 and 1994. We may see some carnage among hedge funds, but they are seldom systemically significant.
With respect to my own portfolio, I am expecting mild turbulence but still remain bullish on equities. I think that the equity risk premium is sufficiently large to absorb whatever happens in bonds (and I don’t expect much).