Experts Say: 2017-03-10

Danielle DiMartino Booth - A former adviser to the president of the Dallas Fed

Investors watch for clouds on the bond market horizon

Danielle DiMartino Booth, a former adviser to the president of the Dallas Fed, speculates about vague outlook on the US bond market horizon.

“Global bond investors could be in for a nasty wake-up call. Amid all the euphoria surrounding Trumponomics, traditionally dovish US Federal Reserve officials have begun to sound like passionate hawks. Not only are multiple interest rate rises priced into the markets this year, officials have also crossed into previously sacrosanct territory, countenancing a shrinking of the Fed's $4.5tn balance sheet.

Taking this next step to leave the era of unconventional monetary policy behind would effectively double down on the tightening in financial conditions. There is a growing risk, therefore, that the long era of calm in the global bond market is coming to an abrupt halt,” Danielle DiMartino Booth says.

“One of the first lessons of economics is that money is fungible — it can be repurposed at will. Global bond investors have adapted the idea of fungibility to quantitative easing. They are largely indifferent to which central bank is purchasing securities; the point is that some central bank balance sheet somewhere is growing. Add up the easing exertions and you get to $200bn or so every month, all of which is mutually interchangeable for the purpose of keeping animal spirits buoyant.

Investors' steep assumptions do not stop there, though, for this is where that other basic tenet of economics — the law of supply and demand — comes into play. The lowest bond yields in 5,000 years also reflect the belief that central banks' bond purchases permanently expunge supply from the market,” the expert notes.

“It is hard, therefore, to envision global bond investors retaining their composure as the assumption under which they have purchased dearly priced bonds in recent years vanishes. If the Fed has seen fit to allow global bond supply to begin expanding anew, what is to stop its central banking peers from following suit?

More disturbing yet is that inflation data now warrant tightening after years of price pressures being subdued. At 2.5%, the consumer price index in the US is the highest in five years. Even the “core”, which excludes food and energy prices, stands at 2.3 per cent over the past year.

Mario Draghi, president of the European Central Bank, is under a bit less pressure with headline inflation in the eurozone hitting 2% in February, but the core unchanged at 0.9 per cent. The data alone, however, will not ease tensions between those in Germany calling for a tapering of the ECB's bond purchases and those in the eurozone's peripheral economies who benefit from continued stimulus. Heavily influenced by rising oil prices, import prices in Germany have jumped 6 per cent, the most since May 2011,” the expert adds.

“These data provide Mr Draghi with cover to signal that the time has come to begin a gradual exit from QE when the ECB meets on Tuesday.

The recent behaviour of equity prices suggests investors do not believe policymakers will follow through on their threats, that they will not dramatically tighten conditions to the extent that a stock market correction is set off. Rather, the thinking is that investors will rotate money into stocks and out of bonds. So far that has been the case. In late December, Torsten Slok, Deutsche Bank's chief international economist, noted that in reaction to rising bond yields, in the six weeks to December 20, investors pulled $3tn from the global bond market and ploughed the same amount into stocks,” Booth continues.

“What a difference a few months can make. In August 2016, the value of negative-yielding bonds reached $13.4tn as QE shifted into overdrive. Should next week's Fed statement nod to the possibility of shrinking the balance sheet, investors would be well advised to make sure their seat belts are fastened in the event that the brakes are slammed on the bond market's magnificent 36-year run,” the expert sums up.

Published: 2017-03-10
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