The financial markets have had a bit of a tough time going anywhere this year.
The S&P 500 has been caught in a 6% trading band all year, capped on the upside by a 3% gain and on the downside by a 3% price loss. It has been a back-and-forth flurry while the stock market up to this point has simply marked time.
We’ve seen a bit of the same in the bond market: after rising 3.5% in the first month of the year, the ten year Treasury bond has given away its year-to-date gains and then some.
2015 stands in relative contrast to largely upward stock and bond market movement over the past three years. What’s different this year and what are the risks to investment outcomes ahead?
Higher Interest Rates Ahead
As I have suggested in recent discussions, the probabilities are very high the US Federal Reserve will raise interest rates this year. Yes, Ms. Yellen intimated it may come later, but remember she also canceled her appearance at the Fed’s annual Jackson Hole soiree this year, a meeting that takes place just a bit before the September Fed FOMC meeting. I think the markets are attempting to “price in” the first interest rate increase in close to a decade.
Importantly, we're talking about the re-pricing of credit in the US financial system and economy broadly. We all know how important credit has been to underpinning the US economy for literally decades now. I believe this is a key part of the story of why markets are acting as they are in 2015. However, there are much larger longer term issues facing investors lurking well beyond the short term Fed interest rate increase to come: bond yields (interest rates) rest at generational lows and prices at generational highs – levels never seen before by investors. Let’s set the stage a bit, because the origins of this secular issue reach back over three decades.
30 Years Of Lowering
It may seem hard to remember, but in September of 1981, the yield on the ten year US Treasury bond hit a monthly peak of 15.32%. At the time, Fed Chairman Paul Volcker was conquering long-simmering inflationary pressures in the US economy by hiking interest rates to levels no one alive had ever seen. 31 years later, in July of 2012, that same yield on 10 year Treasury bonds stood at 1.53%, a 90% decline in coupon yield, as Fed Chairman Bernanke was attempting to slay the perception of deflation with the lowest level of interest rates investors had ever experienced.
This 1981-to-present period encompasses one of the greatest bond bull markets in US history, and certainly over our lifetimes. Importantly, existing bond prices rise when interest rates fall, and vice versa. So from 1981 through the present, bond investors have been rewarded with coupon yield (ongoing cash flow) and rising prices (price appreciation via continually lower interest rates). Remember, this is what has already happened.
As always, what is most important to investors is not what happened yesterday, but rather what they believe will happen tomorrow. Although this is not about to occur instantaneously, the longer term direction of interest rates globally has only one road to travel – up. The key questions ultimately being, how fast and how high? Why is this important?
We Have No Experience With Rising Rates
This is important for a number of reasons.
First, since the late 1970’s, bond investments have been considered a “safe haven” destination for investors during periods of equity market and general economic turmoil. In other words, the entirety of the career, if not more, of most investors today. How many of today’s bond pro’s, let alone mom and pop investors, have experience navigating a bond bear market? With all due humility I’d suggest the answer is little to none. With interest rates at near generational lows and prices at near all-time highs, forward bond market price risk has never been higher in the experience of the investment community of today. An asset class that has almost always been considered safe, is no longer, regardless of what happens to stock prices at any point in time.
We need to remember that so much of what has occurred in the current market cycle has been built on “confidence” in Central Bankers globally. Central Bankers control very short term interest rates (think money market fund rates). Yes, quantitative easing allowed these Central Banks to print money and buy longer maturity bonds, influencing longer term yields for a time. That’s over for now in the US, although it is still occurring in Japan and Europe. And cross border capital flows are more important than perhaps at any time in recent memory.
The New Era Of Central Bank Panic
So it's very important to note that over the last five months, we have witnessed the 10 year US Treasury yields move from 1.67% to 2.4%+, and the Fed never lifted a finger.
In Germany, the yield on a 10 year German Government Bund was roughly .05% a month ago. As you may know, the interim high was a few ticks above 1%. That’s a 20 fold increase in the ten year German Bund rate inside of a month’s time. Now that’s a liquid market! And you think this was lost on Central Bankers?
To the point, for a global market that has risen at least in part on the back of confidence in Central Bankers, this type of volatility we have seen in longer term global bond yields as of late implies investors may be concerned Central Bankers are starting to “lose control” of their respective bond markets.
Put another way, investors may be starting to lose confidence in Central Bank policies being further supportive of bond investments.
This is not a positive development in a cycle where this buildup of confidence has been such a meaningful support to financial asset prices in totality. If the investment community ever came to believe, even for a short time, that Central Banks had lost control of their respective bond markets, well… you haven’t even seen volatility yet.
As Go The Credit Markets, So Goes The World
Although the Street seems to agonize over equity valuations and recent price volatility, as I see it the real issue is the global bond market. Why?
Globally, the value of outstanding credit instruments is three times the total value of publicly traded equities. Just which do you imagine is more important to institutional investors?
As we think about the potential for global capital movements not only geographically, but also as movement among asset classes, all eyes should be on the global credit markets. So much capital is stored there that if it starts flowing out, and likely to the sidelines (i.e. safe havens), prices for everything are going to be impacted. And losses to today's most commonly-held financial securities could be absolutely tremendous.
In Part 2: What Awaits Us In The Future Of Higher Interest Rates we detail the long-forgotten aspects of life under higher interest rates. High prices, debt defaults, moribund markets — remember the 1970s? — the ghosts of the past are about to return. Joined this time, though, by the spectre of a collapse of the $700 trillion derivatives market — which if it happens, will make the '70s look like the roaring '20s.