The past few weeks have given us a hint of what might happen when the Federal Reserve starts to reverse its super-easy monetary policy. Expect turbulence in financial markets, especially for assets that have moved far above normal or reasonable valuations.
A return to normality eventually implies a benchmark 10-year treasury yield of 4% or more. It won’t happen all at once, but that’s where we’re heading. With yields at roughly 2.2%, there’s a long way to go. This transition will mark a recovery of the equity culture and the cooling of investors’ protracted love affair with bonds.
Because of this prospect, markets are sensitive to the merest whiff that Fed chairman Ben Bernanke might be forced by colleagues on the Federal Open Market Committee to reduce the scale of quantitative easing. This nervousness has affected asset prices across the maturity spectrum, not just at the short end of the money market as you might expect.
To those of us who were paying attention back in 1994, it all seems quite familiar. Chairman Alan Greenspan had made it reasonably clear that the Fed was about to start raising rates. Even so, the news seemed to come as a shock. I remember being on a trip to Australia after the Fed made its move. From the scale of the sell-off in Australian bonds, you’d have thought an inflation panic was breaking out, or that the Fed had lost all credibility—but no, it was simply that many people had invested heavily in Australian (and European and other developed-market) bonds to take advantage of the yield spread over US treasuries.
In recent years, the search for yield has gone wider and deeper. The resulting deviation from normal valuations has been amplified by the shift of pension funds and insurance companies out of equities into fashionable bonds, and by the lingering effects of the great financial crisis of 2008 and 2009. It seems inevitable that some version of the shock of 1994 is going to happen again.
Many policymakers will bore you endlessly with what they’ve learnt from past mistakes, on their superior understanding of the hazards, their improved communication skills, and so forth. This time, they say, when the Fed and others make their move to withdraw monetary stimulus, the fallout will be nothing to worry about. The past few weeks say otherwise.
High-yield complex municipal bonds and emerging market bonds are quite likely to suffer a bit more than US treasuries when the moment comes. The same probably goes for gold (though you might think it has suffered enough in recent months). I wouldn’t mind betting that much-unloved peripheral European bonds will end up being a better thing to own when this happens—along with various reasonably valued equity markets, of course.
Under Bernanke, the Fed is far more preoccupied with guiding investors’ expectations than Greenspan ever was. Bernanke stands for transparency; Greenspan often took pride in his opacity. I don’t expect this to make much difference. Recent weeks suggest that transparency doesn’t mean clarity. Fed can talk about tapering QE all it likes; it can’t change the basic laws of economics and valuation.
A rise in the benchmark yield to 4% would represent normality even if inflation expectations stayed well controlled. They might not. If inflation expectations (as measured, say, by the University of Michigan’s survey) picked up, there’d be a bigger premium. How much would that matter? In recent years, I have listened as a number of bond investors have tried to convince me that a basket of top-quality large non-financial corporate bonds would represent a much better benchmark than US treasuries. My answer has always been, let’s see what happens when the Fed becomes less generous.
I’ve a lot of time for those who’ve argued for better global benchmarks for bonds—for instance, giving greater weight to so-called emerging-market bonds—but this should never have been taken as a reason to buy large amounts of any emerging country’s bonds irrespective of the country’s fundamentals or its bonds’ spreads over US treasuries.
In the short term, getting back to normal probably means some fallout across equity markets, too—but this is much less likely to be lasting. Longer-term investors will want more exposure to equities, not less. Normality means a reversal in the popularity of the two main asset classes: As people fall out of love with bonds, they’ll fall back in love with equities. Bloomberg
Jim O’Neill, former chairman of Goldman Sachs Asset Management, is a Bloomberg View columnist.