Voices questioning the unconventional monetary policy measures of global central banks are becoming stronger by the day. They gained further mojo when Bank of Japan (BoJ) last week decided to control the entire yield curve by setting a rate target for long-term bonds.
Given that the three big central banks, BoJ, the US Federal Reserve and the European Central Bank, have infused trillions of dollars into markets ever since Fed began quantitative easing in 2009, it is entirely valid to get jittery on where exactly all the money is making a difference. Japan is still not convincingly out of deflation, and the European Union economies are struggling to grow even today. Fed is struggling to normalize its rates.
Now look at fixed income markets globally. The yield curve of the Japanese bond market is getting buried in negative territory as are yields in Germany and Switzerland. Yields on sovereign securities in Italy, Spain and even the UK are perilously close to zero. According to a Fitch Ratings report, the universe of negative yielding bonds stands at $10.9 trillion and more than half of this originates in Japan. To put it in perspective, that is roughly the size of China’s economy and investors are actually paying to hold these bonds.
The only way investors will make a profit is when negative yields fall further. However, the snap in this trend is already under way with yields inching up. Fitch in the same report notes that the outstanding sovereign bond stock in the realm of negative yields has dropped in the last two months.
Bond markets rife with distortions are bound to throw a tantrum as central banks try to unwind (in the case of Fed) or even twist (in the case of BoJ) their measures. Central bankers may not want another taper tantrum but signs of the same are appearing. Once negative yields start moving up towards zero and then positive territory, the bond market will stare at huge losses. A Bloomberg report notes that the 10-year US government bond yield is lower than the stock market dividend yield. In the previous episodes of such a case—only twice—bonds had suffered record annual losses.
In a 2 August report, Fitch states a hypothetical case of yields moving back to 2011 levels. This would cause an aggregate loss of $3.8 trillion to bond markets, the rating agency believes. Juxtapose this with the maze of cross-border fund flows and ripples across markets are inevitable.
Where would India stand when it pops? In the previous two episodes of a major sell-off in international bond and equity markets, both in 2008 and 2013, Indian equities and bonds were battered too. Being part of the emerging market group, the country cannot escape a negative impact. We have to be prepared for it.