The recent sell-off in global bond markets caught everybody by surprise.
The US 10-year treasury note hit a five-year high, UK benchmark yields climbed to a nine-year peak, German bund yields are at their highest since 2002, the 10-year Japanese government bond yield has jumped to near 2% levels. Back home, the yield on the benchmark 10-year government bond rose to a five-and-a-half year top.
Higher interest rates are anathema to equity markets. That’s especially true about US interest rates, because there’s a lurking fear that the real estate market there is fragile and rising bond yields, which mean higher mortgage rates, could lead to a slump in the housing sector. That could hurt the all-important American consumer, who has done so much for the world economy by getting ever deeper into debt and using the money to buy goods and services from other countries, which has kept factories humming in those places.
A grateful world has reciprocated the kindness by investing their surpluses in low-yielding US treasuries and in a declining dollar, notwithstanding the loss, in the hope that the US consumer would be induced to continue his debt binge.
That’s the storyline that threatens to unravel if US bond yields rise and the US consumer wilts, so it’s no wonder that stocks across the world tumble whenever there’s an interest rate scare.
The comfort is that there are several things wrong with that storyline, the most obvious one being that if US bond yields rise and the dollar starts appreciating, those central banks that have so generously invested in US treasuries would have even greater reason to do so.
So why did investors sell US bonds so suddenly?
One theory doing the rounds is about the inevitable Chinese connection. The Chinese government’s decision to start a sovereign investment fund, it is argued, would lead to less money flowing into US treasuries. Hence the sell-off. A conspiracy version of the theory says that the inscrutable Chinese know very well that they have the power to move the US bond market.
However, they have no intention of rocking the new world order by selling US bonds, as they would be hurt the most by the market fallout. But if they stayed away from the bond market for some time, that would ensure higher yields, which would benefit them considerably.
The Chinese have been known to play the commodity markets in this way, taking advantage of the fact that they are the 500 pound giant panda that can move prices.
The Bank for International Settlements’ Quarterly Review offers a simpler explanation. It points out that long-term bond yields in Europe have steadily gone up after the February scare, on investors’ perceptions of the strength of the Euro area economy, which has continued to do well in spite of a rising currency. In the US, however, bond yields remained depressed initially because analysts were lowering US GDP forecasts on persistent worries related to the weak housing market. Towards the end of May, “bond yields rose as the release of stronger-than-expected employment data and other favourable economic indicators induced renewed optimism among investors concerning the US economy”.
But should we lay the blame for the latest scare at the door of higher growth prospects?
Consider The Economist magazine’s poll of economists. Here’s their current forecast of GDP growth for the biggest developed economies in 2008: US 2.7%; UK 2.5%; Euroland 2.2%; Japan 2.3%. Back in March, when the markets were tottering because they were scared growth will slow in the US, the forecasts looked like this: US 2.9%; UK 2.6%; the Euro area 2.2%; Japan 2.3%. As the numbers show, there’s hardly any change. Among the developing economies, the poll’s estimate for China’s GDP growth in 2008 is 9.7%, the same as it was back in March. For India, the current forecast is 7.6% compared with 7.8% in March.
Growth perceptions, therefore, don’t seem to have changed. Of course, it’s entirely possible that the markets have an entirely different view of future GDP growth than The Economist’s poll.
And finally, pundits have speculated that what’s happening now is merely a normalization of interest rates and the end of Alan Greenspan’s famous conundrum that US bond prices remained low in spite of higher policy rates.
But something doesn’t quite ring true about this latest scare. For instance, unlike last February, when the carry trades started to unwind and the yen soared, this time the yen is testing new lows and the carry trade is flourishing. Also, Fed funds futures through March are not pricing in any increase in the Fed funds rate, which should have happened if growth and inflation surprise on the upside.
It’s probably because of these reasons that most research outfits have advised their customers to buy into the sell-off.
A Citigroup note on global equity strategy titled Bull not done yet says that “even with the recent sell-off, global bond yields would need to rise another 150bp to close out the gap against equities”.
Says global independent research outfit Bank Credit Analyst: “Global equities would still be inexpensive compared with bonds if yields rose another percentage point in aggregate. Bottom line: Recent equity market weakness should not be viewed as anything more than a bull market correction. Further weakness is likely, but buying on dips is the right strategy.”
Mint’s resident market expert Manas Chakravarty looks at trends and issues related to investing in general and Indian bourses in particular. Your comments are welcome at firstname.lastname@example.org.