In the space of a few hours on Wednesday last week, the yield on the US 10-year Treasury bond tumbled from 2.19 per cent to 1.86 per cent, an eye-watering move that weaker than expected US retail sales could never explain. Swap rates in the UK also fell sharply as interest rates are indicated to stay on hold for longer – Is this a Return to ‘Normal’ Markets?
It was a fairly unprecedented move, at least in ‘normal’ markets post the financial crisis. Not even a spike in equity risk aversion could explain the rise in US government bond prices. Wall Street’s fear gauge, the Vix index, spiked 36 per cent to a reading of 31 at one stage, still well below the levels during previous market sell-off in the autumn of 2011.
There is only one rational explanation for what was going on: a huge liquidity squeeze and short covering by hedge funds and trading companies exiting short positions on US Treasuries. That’s because some financial institutions had previously been betting that the US central bank would start raising rates next year.
This scenario is still highly likely to play out in my view as interest rates are normalised.
The Fed is likely to start to hike the policy rate in the third quarter of 2015 and lift the policy rate to a 4 per cent neutral level by the end of 2018.
The bank is still maintaining its baseline view, but also notes that “the market seems clearly more concerned than we are about the effect of a deceleration in euro area and global growth on the US economy, and has repriced the future stance of monetary policy, pushing the timing of the lift-off date (of the first rate rise) from June 2015 to September 2015.
In other words, forced selling by highly-geared traders exiting losing short-government bond positions sparked the initial price move in fixed-income markets.
Furthermore, given the spike in risk aversion investors are more likely to seek sanctuary in safe-haven US government bonds in such a risk-off environment. In turn, this has acerbated the price move.
The same is true for the UK.
Indeed, the spike in government bond prices this week fails to factor in the important point that the downward move in commodity prices and the strength of the US dollar are actually supportive of a normalisation of US monetary policy. In fact, the 24 per cent slide in US crude oil since the end of June is tantamount to a tax cut. Also, the 8 per cent appreciation in the dollar index since May means that imports are cheaper, too. These factors will dampen down US inflation, but not to the extent that the US Federal Reserve will need to change its policy stance.
The same is true of the UK economy as the price of Brent Crude has fallen by 28 per cent since June and is helping to lower inflation here. But with employment at record levels, and unemployment rates at their lowest level since the financial crisis began in 2008, the margin of spare capacity is shrinking rapidly. This points to a higher inflationary outlook as wage inflation is allowed to ramp up. The risk of delaying a rise in interest rates in the UK is that if this year’s falls in commodity prices prove temporary, then sterling’s strength will have masked inflationary pressures that would have otherwise been seen in the official data.
Investors are paying little attention to this right now and undoubtedly will not until the ‘growth scare’ spooking them ends. However, when markets return to some form of normality, then the rock-bottom yields on safe-haven UK and US government bonds, and the elevated risk premium factored into equity market valuations, and in particular in the smaller end of the market which has been savagely derated across the board, will undoubtedly unwind. There are rich pickings to be had in the debris, and the 2014 stock market sale is now on for bargain hunters.