Global Bond Markets

by George Hatjoullis

Bond markets have managed to achieve yields I never thought possible. Global deflationary forces are evident so this is not illogical. The level of yields and volume of wealth invested in Bonds is now such that the markets are vulnerable to shocks. A sell off in bonds does not require an end to global deflationary forces. It merely requires a degree of caution sufficient to result in profit taking and a market failure. This can lead to a cascade of falling prices and rising yields. It may be temporary but it can still happen. I explored this scenario in Liquidity and Market failure:lessons from 1994. At the time it seemed this scenario might unfold from the summer of 2015. It did not. The conditions for this scenario have however improved dramatically with the rise of populism.

Donald Trump clearly signalled he would seek a change in the policy mix from easy money/tight fiscal to tighter money/easier fiscal. I am not sure how tight US fiscal policy really is nor how he proposes to change Federal Reserve monetary policy but the fact that he speaks in these terms is enough to spook somewhat overweight complacent markets. Yields have already begun to rise. A little less easy money and a little more fiscal laxity is not per se a bad idea. The problem with populists is that they are not concerned with the optimal policy mix. They are concerned with the optimal re-election mix. Some cynics would argue this is true of all politicians but this is self-evidently not the case. We have had austerity policies and easy money globally since 2008 despite electoral grumbling and indeed it is, in part, this policy mix that has allowed populists into power. The problem with populists is that they have tendency to over do it on the fiscal laxity leading to a sub-optimal policy mix. It is this risk that the bond markets need to re-price.

The populist government of T. May in the UK is also showing signs of changing the policy mix. The electorate that voted for the Conservative Party at the last election were quite happy with easy money/tight fiscal. They were quite happy with retaining membership of the single market for that matter. The referendum removed the government that won the last election and replaced it with an unelected populist government. The prospect of leaving the single market has triggered a collapse of sterling and inflicted an inflation shock. The populist government has openly criticised the Bank of England for its easy money policies and the Chancellor has started to speak of breathing space for fiscal laxity. Again, the change in the policy mix is not necessarily a bad thing but the markets are nervous of populist governments and fiscal policy, especially when there is a huge inflation shock to absorb.

The same cannot be said of the rest of the world of course. The limits to easy money are being recognised but there is no universal move to easier fiscal policy, and certainly not within the euro zone. One should not underestimate the cross-correlation in bond markets and the influence of the US Treasury market. If US Treasury yields rise other markets will not be immune and, if other market yields rise quickly enough, market failure may still occur. It is also evident that commodity prices have stabilised and are bouncing quite convincingly. Perhaps global deflation is over.

One of the problems with exiting bond markets is where to place the funds. Banks no longer offer that sense of security as none are too big to fail. A move down the yield curve is most likely so an abrupt steepening might well materialise. This is not normally good for any asset class though the experience of 1994 suggests equities can rally as a class through a market failure event. Certainly some equities will be benefitting from the easier fiscal conditions.

To be clear, I am not suggesting bond yields have begun a secular rise. I am suggesting the conditions are in place for a painful correction. It will be painful largely because of market failure (as in 1994) and not because of ‘fundamentals’. The trigger could well be the rhetoric of populist governments. If these governments survive and follow through with their rhetoric, long run inflation expectations may well rise and thus signal a secular rise in yields. This remains to be seen but the fear may be enough to kick off a nasty correction.