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Bond sell-off is a warning to the Fed

The writer is president of Queens’ College, Cambridge and an adviser to Allianz and Gramercy

The combination of extremely low and relatively stable US government bond yields has confounded many market watchers for quite a while now, also challenging traditional economic analyses.

This has made the move up in yields over the past couple of weeks particularly notable, raising interesting questions for markets, policies and therefore the global economy.

It is usual to characterise US benchmark government bond yields as the most important market indicator in the world. Traditionally, they have signalled expectations about growth and inflation in the world’s most powerful economy. They have been the basis for pricing in many other markets around the world.

Breaking with a long history, these benchmark measures decoupled in recent years from economic developments and prospects. Their longstanding correlations with other financial assets, including stocks, broke down.

And their information content became distorted and less valuable. Coming out of the 2008 global financial crisis, this was attributed to excess global savings that exerted consistent downward pressures on yields.

With time, however, it became clear that the main driver was the ample and predictable purchasing of government bonds by the world’s most powerful central banks under quantitative easing programmes, particularly the US Federal Reserve and the European Central Bank.

One should never underestimate the power of central banks intervening in market pricing.

The trillions of dollars of bonds purchased by the Fed and ECB have distorted the usual two-sided markets and encouraged many to buy a whole range of assets well beyond what they would normally do on the basis of fundamentals.

After all, what is more assuring that a central bank with a fully-functioning printing press willing and able to buy assets at non-commercial levels. Such purchases legitimatise previous private sector investments and provide assurance that there will be ready buyers of assets for those needing to sell to reposition portfolios.

It is a set-up that encourages private sector “front-running” of purchases by central banks at prices that would have traditionally been deemed unattractive. No wonder that even those convinced of a fundamental mispricing have been hesitant to be on the other side of a bond market dominated by central banks.

While these factors remain in play, yields have slowly but consistently been migrating up in the past two weeks from 1.30 per cent for the 10-year bond to 1.50 per cent.

With global growth prospects dampening somewhat due to the Delta variant of Covid-19, the drivers have been a mix of mounting inflationary pressures and multiplying signs that central banks will struggle to maintain the era of “QE infinity” — that is, endlessly ultra loose financial conditions. The signs in recent days have included statements from the Bank of England and higher rates in Norway adding to moves in some developing countries.

The more rate volatility increases, the greater the risk of yields suddenly “gapping” upwards given that we are starting with a combination of very low yields and extremely one-sided market positioning. The greater the gapping, the bigger the threat to market functioning and financial stability, and the higher risk of stagflation — the combination of rising inflation and low economic growth.

Like a ball deeply submerged in water, a combination of market accident and policy mistake could result in a move up in yields that would be hard for many to handle.

Importantly, this does not mean that central banks, and the Fed in particular, should delay what should have already started — that is, embarking on the tapering of what, curiously, is the same level of monthly asset purchases ($120bn) as at the height of the Covid-19 emergency 18 months ago.

On the contrary, the longer the Fed waits, the more markets will question its understanding of ongoing inflationary pressures, and the higher the risk of disorderly market adjustments undermining a recovery that needs to be strong, inclusive and sustainable.

For their part, investors should recognise that the enormous beneficial impact on asset prices of prolonged central bank yield repression comes with a consequential possibility of collateral damage and unintended consequences. Indeed, they need only look at how hard it has become to find the type of reliable diversifiers that help underpin the old portfolio mix of return potential and risk mitigation.


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