The US Federal Reserve under the tenure of Janet Yellen has raised rates five times, and is likely to do so three times this year, but bond prices have stayed sky-high © AFP
A few years ago, the head of a leading western central bank predicted that his job would soon be akin to flying a plane. The reason? Eventually, central banks in Europe, US and Japan would tighten monetary policy. After all, the supposedly emergency stimulus that central banks provided after the 2008 crisis could not remain in place forever.
But what central banks desperately needed to do, he explained, was withdraw that stimulus at a controlled pace, like a pilot landing a plane. The goal was to deliver such a smooth glide path for this “landing”, meaning a return to more normal interest rates, that investors would barely notice, let alone panic.
Can this glide path ever be achieved without tipping markets into a tailspin? That is the question investors must contemplate. In recent months, the issue that has grabbed most market headlines has been the sky-high level of equity prices, particularly in the US.
But it is the behaviour of bond prices that is more remarkable. A decade ago, popular investing wisdom posited that bond prices should fall when equities rise, especially if central banks were raising rates. But although the US Federal Reserve under the tenure of Janet Yellen has raised rates five times, and is likely to do so three times this year, bond prices have stayed sky-high, keeping long-term yields ultra low (prices and yields move inversely).
That means that the US yield curve (or the gap between long and short rates) has flattened. It also means that financial conditions in the markets “are extremely accommodative”, as Jan Hatzius of Goldman Sachs says.
But now bond prices are wobbling. This week the 10-year US yield jumped to nearly 2.6 per cent, its highest level for almost a year, after speculation that the central banks of China and Japan might be scaling back their Treasury purchases. Yields later fell back. But the swing was sharp enough to prompt Bill Gross and his rival and fellow guru Jeffrey Gundlach to warn that the three-decade-old bull market for bonds might be coming to an end (although they differ on the precise timing).
If so, this shift might not necessarily be a bad thing. After all, the current low level of rates looks peculiar and has fuelled all manner of asset price bubbles. An adjustment is inevitable at some point, and desired by the Fed. “The bond market is waking up to what the Fed is doing,” says Stephen Macklow Smith, an analyst at JPMorgan.
But the crucial issue now is the slope of the glide path. If rates start rising steadily there is every chance that the financial system can absorb this. But if they climb quickly, that could create a snowball effect of a kind last seen in 1994 (when the Fed unexpectedly raised rates).
The reason is that the long era of ultra-low interest rates has lulled many institutions into complacency. Investors have been reaching for yield, that is taking additional credit risks, on the presumption that rates will stay low, and using derivatives to magnify their bets. Nobody really knows how much exposure this has created, since the $400tn over-the-counter swaps market is so opaque.
But there will almost certainly be big losses in the system if rates did jump higher. Leveraged corporate borrowers, and even governments, would also suffer shocks. The Congressional Budget Office calculated that costs on US federal debt will rise from $270bn to $712bn over the next decade if 10-year yields rise from 1.8 per cent to 3.6 per cent (excluding the Trump tax cuts). If that happened in just one year, it would be deeply painful.
Thankfully, there is no sign of this type of shock yet. And there are plenty of factors that could prevent a sudden surge in rates. Inflation is subdued, the economy seems to have plenty of spare capacity and investors still appear keen to buy bonds. When the US Treasury held an auction of 10-year bonds this week it was more over-subscribed than at any point for a year.
But the essential lesson is that the longer investors, governments, companies and financial institutions think that rates will stay low, the greater the risk that any sudden decline in bond prices will lead to a repeat of what happened in 1994.
Conversely, the more that investors worry about a “bondmageddon”, the greater the chance that they will start positioning their portfolios in a manner that enables central bankers to deliver a smooth glide path. So central bankers should say a hearty “thank you” to Messrs Gross and Gundlach. Sometimes a whiff of drama is just what is needed to produce a calmer world.