20-05-2013, 12:49 AM
If you believe in 10 year cycle for stock market, the year that ends with 4 will be the start of the jittery...
Bond-market bloodbath is unlikely, yet
Bassanese David Bassanese
1063 words
20 May 2013
The Australian Financial Review
AFNR
English
Copyright 2013. Fairfax Media Management Pty Limited.
David Bassanese
The party has been great so far, but there is growing nervousness on Wall Street that the US Federal Reserve is about to start draining the punch bowl. Fed chairman Ben Bernanke testifies before Congress this Wednesday, and traders fear he might hint at a tapering down of the central bank's $US85 billion per month bond-buying program – which would be a prelude to an eventual lift in interest rates.
Indeed, with the US economy continuing to improve and US interest rates still very low, many veteran market participants are starting to debate the risks of an eventual 1994 bond-market sell-off, which shattered the psyche of many fixed-income traders during that eventful year.
For those that don't know, 1994 saw US interest rates spike ever higher – a wrenching upward spiral that caught many unsuspecting investors long bonds and in a world of pain.
US 10-year Treasury bonds surged from around 5.7 per cent at the start of the year to a peak of 8 per cent by November.
Australia's market was not spared the pain with 10-year government bond yields rising from around 6.4 per cent to 10.7 per cent over the year. Of course, 1994 was a long time ago.
Most traders and fund managers aged under 40 were too young to have experienced the gut-wrenching bloodbath. And many are now happily buying US 10-year Treasury bonds with a yield less than 2 per cent due to the "positive carry" achieved by borrowing in the US cash market at a practically zero interest rate.
As the saying goes, however, profiting from the US bond carry trade with the economy getting better seems a bit like picking up pennies in front of a steam roller.
In the face of generally good news on the economy, it's reasonable that speculation of Fed tightening would re-surface. To my mind, however, while a bond-market bloodbath is quite possible in the next few years, it seems highly unlikely – and does not seem especially likely to occur anytime soon. Non-threatening
For starters, both inflation itself and inflation expectations these days are much lower and more firmly established than 20 years ago. And at 7.5 per cent, the US unemployment rate is still at least a year or two from reaching the 6.5 per cent level at which the Fed said it would start raising overnight interest rates.
At the same time, core inflation remains very non-threatening, with the annual growth in the private consumer expenditure deflator (excluding food and energy) slowing over the past year to near previous global financial crisis lows of 1.1 per cent.
The big drag from the recent tightening in fiscal policy has yet to fully hit the economy. Taxes were lifted at the start of the year, but a range of new spending cuts only took effect from March 1.
All up, I suspect Bernanke still likely believes the US recovery remains too fragile to risk a sudden lurch higher in bond yields – as might result should he hint at a near-term scaling back of the bond buying program. And as for the possible "bubble effects" in financial markets from keeping interest rates so low for so long, Bernanke continues to place greater store in America's new so-called "macro-prudential" tools, such as higher capital ratios and closer supervision of large financial institutions and the shadow banking sector.
That said, assuming America's economy continues to recover and does not descend into a Japanese style rut, the bond-buying program will likely end by early next year.
And it's inevitable that the Fed will raise interest rates and that bond yields rise from their current unusually low level.
Even then it's by no mean necessary that a 1994-style sell-off will result – indeed, the Fed is probably hoping for a repeat of the 2004 more-managed tightening process instead. This means a longer and more gradual rise in bond yields than in 1994.
Back in 1994 the market seemed quite unprepared for the Fed's tightening program that was unleashed in February that year – and the Fed's subsequent actions were quite aggressive and hard to predict. Raised six times
On the eve of the first 1994 rate cut, 10-year bond yields had only lifted 70 basis points from their trough around four months earlier.
The Fed then raised rates six times that year, though not at every meeting – beginning with three 25 basis point moves, then two 50 basis point moves and culminating in a major 75 basis point hike in November.
A decade later, 10-year bond yields troughed around a year ahead of the Federal Reserve's first rate hike in mid-2004, and had already lifted by 180 basis points.
What's more, unlike in 1994, the Fed telegraphed its moves ahead of schedule, steadily lifting rates at each six-weekly meeting in predictable 25 basis-point moves. Bond yields in fact eased throughout 2004. Why the difference? As noted by JPMorgan US economist Michael Feroli, "in 1994 the Fed wanted much higher interest rates".
It did not merely tap on the brakes, it slammed on them, repeatedly. In turn, that was because Fed officials "thought the economy was essentially already operating quite close to full employment, which meant each upside growth surprise put the Fed at greater risk of falling behind the curve."
Of course, what the Fed will end up needing to do in the next year or so will depend on the economy.
But as in 2004, it's likely the Fed will try hard to smooth the upward adjustment in bond yields.
What about equities? Note that in 1994, the US S&P 500 index still only dropped 4.5 per cent from the eve of the first rate hike to year end – half of which came on the day of the first move.
In 2004, the market hardly flinched on the day of the first rate hike in late June, and ended in the year 6.6 per cent higher.
It's not the early stages of Fed tightening cycle that kills an equity bull market, but rather the latter stages.
Fairfax Media Management Pty Limited
Document AFNR000020130519e95k00015
Bond-market bloodbath is unlikely, yet
Bassanese David Bassanese
1063 words
20 May 2013
The Australian Financial Review
AFNR
English
Copyright 2013. Fairfax Media Management Pty Limited.
David Bassanese
The party has been great so far, but there is growing nervousness on Wall Street that the US Federal Reserve is about to start draining the punch bowl. Fed chairman Ben Bernanke testifies before Congress this Wednesday, and traders fear he might hint at a tapering down of the central bank's $US85 billion per month bond-buying program – which would be a prelude to an eventual lift in interest rates.
Indeed, with the US economy continuing to improve and US interest rates still very low, many veteran market participants are starting to debate the risks of an eventual 1994 bond-market sell-off, which shattered the psyche of many fixed-income traders during that eventful year.
For those that don't know, 1994 saw US interest rates spike ever higher – a wrenching upward spiral that caught many unsuspecting investors long bonds and in a world of pain.
US 10-year Treasury bonds surged from around 5.7 per cent at the start of the year to a peak of 8 per cent by November.
Australia's market was not spared the pain with 10-year government bond yields rising from around 6.4 per cent to 10.7 per cent over the year. Of course, 1994 was a long time ago.
Most traders and fund managers aged under 40 were too young to have experienced the gut-wrenching bloodbath. And many are now happily buying US 10-year Treasury bonds with a yield less than 2 per cent due to the "positive carry" achieved by borrowing in the US cash market at a practically zero interest rate.
As the saying goes, however, profiting from the US bond carry trade with the economy getting better seems a bit like picking up pennies in front of a steam roller.
In the face of generally good news on the economy, it's reasonable that speculation of Fed tightening would re-surface. To my mind, however, while a bond-market bloodbath is quite possible in the next few years, it seems highly unlikely – and does not seem especially likely to occur anytime soon. Non-threatening
For starters, both inflation itself and inflation expectations these days are much lower and more firmly established than 20 years ago. And at 7.5 per cent, the US unemployment rate is still at least a year or two from reaching the 6.5 per cent level at which the Fed said it would start raising overnight interest rates.
At the same time, core inflation remains very non-threatening, with the annual growth in the private consumer expenditure deflator (excluding food and energy) slowing over the past year to near previous global financial crisis lows of 1.1 per cent.
The big drag from the recent tightening in fiscal policy has yet to fully hit the economy. Taxes were lifted at the start of the year, but a range of new spending cuts only took effect from March 1.
All up, I suspect Bernanke still likely believes the US recovery remains too fragile to risk a sudden lurch higher in bond yields – as might result should he hint at a near-term scaling back of the bond buying program. And as for the possible "bubble effects" in financial markets from keeping interest rates so low for so long, Bernanke continues to place greater store in America's new so-called "macro-prudential" tools, such as higher capital ratios and closer supervision of large financial institutions and the shadow banking sector.
That said, assuming America's economy continues to recover and does not descend into a Japanese style rut, the bond-buying program will likely end by early next year.
And it's inevitable that the Fed will raise interest rates and that bond yields rise from their current unusually low level.
Even then it's by no mean necessary that a 1994-style sell-off will result – indeed, the Fed is probably hoping for a repeat of the 2004 more-managed tightening process instead. This means a longer and more gradual rise in bond yields than in 1994.
Back in 1994 the market seemed quite unprepared for the Fed's tightening program that was unleashed in February that year – and the Fed's subsequent actions were quite aggressive and hard to predict. Raised six times
On the eve of the first 1994 rate cut, 10-year bond yields had only lifted 70 basis points from their trough around four months earlier.
The Fed then raised rates six times that year, though not at every meeting – beginning with three 25 basis point moves, then two 50 basis point moves and culminating in a major 75 basis point hike in November.
A decade later, 10-year bond yields troughed around a year ahead of the Federal Reserve's first rate hike in mid-2004, and had already lifted by 180 basis points.
What's more, unlike in 1994, the Fed telegraphed its moves ahead of schedule, steadily lifting rates at each six-weekly meeting in predictable 25 basis-point moves. Bond yields in fact eased throughout 2004. Why the difference? As noted by JPMorgan US economist Michael Feroli, "in 1994 the Fed wanted much higher interest rates".
It did not merely tap on the brakes, it slammed on them, repeatedly. In turn, that was because Fed officials "thought the economy was essentially already operating quite close to full employment, which meant each upside growth surprise put the Fed at greater risk of falling behind the curve."
Of course, what the Fed will end up needing to do in the next year or so will depend on the economy.
But as in 2004, it's likely the Fed will try hard to smooth the upward adjustment in bond yields.
What about equities? Note that in 1994, the US S&P 500 index still only dropped 4.5 per cent from the eve of the first rate hike to year end – half of which came on the day of the first move.
In 2004, the market hardly flinched on the day of the first rate hike in late June, and ended in the year 6.6 per cent higher.
It's not the early stages of Fed tightening cycle that kills an equity bull market, but rather the latter stages.
Fairfax Media Management Pty Limited
Document AFNR000020130519e95k00015