History teaches that long trends end only when everyone is finally convinced
that they'll keep going.
Maybe no trend in modern times has been as convincing as interest rates. The
yield on long-term Treasury bonds, for instance, has been falling for as long
as most people have been alive:
Same thing for the rest of the developed world. In early 2015 the yield curve
for Swiss government bonds was negative out to ten years, and the curves for
German and Japanese bonds were nearly as extreme. In other words, investors
had to pay for the privilege of lending money to these governments, rather
than the other way around.
That's crazy, but people can adapt to crazy in an amazingly short time. And
lately the discussion has shifted from whether rates can stay this low to how
governments would force them even lower and whether this would require the
abolition of cash itself. See The End
Is Near, Part 1: The War On Cash.
But then, just when we were all finally on board, the interest rate train
started heading back up the hill. The yield on 30-year Treasuries so far this
year:
Why the sudden reversal? It's too soon to tell, but the Telegraph's Ambrose
Evans-Pritchard has some provocative thoughts. Here's an excerpt from a longer,
must-read article:
Markets ignored clear warnings in Europe and America that the money supply
is catching fire, signalling a surge of inflation later this year.
M3 growth in the US has been running at an 8pc rate this year, roughly in
line with post-war averages
The global deflation trade is unwinding with a vengeance. Yields on 10-year
Bunds blew through 1pc today, spearheading a violent repricing of credit
across the world.
The scale is starting to match the 'taper tantrum' of mid-2013 when the
US Federal Reserve issued its first gentle warning that quantitative easing
would not last forever, and that the long-feared inflexion point was nearing
in the international monetary cycle.
Paper losses over the last three months have reached $1.2 trillion. Yields
have jumped by 175 basis points in Indonesia, 160 in South Africa, 150 in
Turkey, 130 in Mexico, and 80 in Australia.
The epicentre is in the eurozone as the "QE" bet goes horribly wrong. Bund
yields hit 1.05pc this morning before falling back in wild trading, up 100
basis points since March. French, Italian, and Spanish yields have moved
in lockstep.
A parallel drama is unfolding in America where the Pimco Total Return Fund
has just revealed that it slashed its holdings of US debt to 8.5pc of total
assets in May, from 23.4pc a month earlier. This sort of move in the staid
fixed income markets is exceedingly rare.
The 10-year US Treasury yield - still the global benchmark price of money
- has jumped 48 points to 2.47pc in eight trading sessions. "It is capitulation
out there, and a lot of pain," said Marc Ostwald from ADM.
The bond crash has been an accident waiting to happen for months. Money
supply aggregates have been surging all this year in Europe and the US, setting
a trap for a small army of hedge funds and 'prop desks' trying to squeeze
a few last drops out of a spent deflation trade. "We we're too dogmatic," confessed
one bond trader at RBS.
Data collected by Gabriel Stein at Oxford Economics shows that 'narrow'
M1 money in the eurozone has been growing at a rate of 16.2pc (annualized)
over the last six months. You do not have to be monetarist expert to see
the glaring anomaly.
Broader M3 money has been rising at an 8.4pc rate on the same measure, a
pace not seen since 2008.
Economic historians will one day ask how it was possible for €2 trillion
of eurozone bonds - a third of the government bond market - to have been
trading at negative yields in the early spring of 2015 even as the reflation
hammer was already coming down with crushing force.
As this is written, US rates are down a bit for the day, so it's possible
that the past few months' spike was only a squiggle in a continuing decline.
But if it's not and rates are finally returning to historically normal levels,
get ready for some serious dislocation. Governments that have borrowed trillions
of dollars, euro, and yen virtually for free (in some cases better than free)
will have to refinance at higher rates, sending their interest costs and therefore
their deficits through the roof. Equities that are valued in relation to bonds
will see those comparisons get a lot tougher. Houses and cars will be harder
to finance, kicking a couple of crucial props from the economy. Volatility,
in short, will return with a vengeance.
On the bright side, savers will once again be rewarded for doing the right
thing. Morally at least, it's a good trade.
