Bonds: What if the sell-off is about growth, not 'QE tapering'?
Martin Steward worries that bond markets are telling a different story than the newspapers.
Volatility is back. US stocks are off their highs, and higher-beta stuff like emerging market equities, bonds and currencies and, especially, Japan's super-heated equity market, have been well and truly battered.
Most media commentary – and, indeed, much industry commentary – has put this down to Ben Bernanke's hint on 22 May that the Fed might begin to "taper" its QE programme as early as this year. Turning off the cheap-dollar tap would dry up all of those global carry trades, the argument goes, so jittery investors have tried to get ahead of the fact by unwinding them now. The same commentators tend to point to the sell-off in Treasuries and murmur darkly about the end of the 30-year bull market in bonds.
But it seems important to me that we at least entertain the possibility that this well-rehearsed story is too simplistic. Risk markets rallied when the US jobs report came in on 7 June. Was that a technical rally, triggered by the fact the unemployment rate (which will ultimately determine the Fed's withdrawal) actually ticked higher to 7.6%? Or because the print of 175,000 new jobs was so much better than the ADP estimate of 135,000 a couple of days earlier? If QE is on the way out, why has the dollar been dropping like a stone since 22 May, and why did gold enjoy a little bounce?
Even the bond markets tell a different story to the familiar one, if we look a bit more closely. I tend to think that the relative movements of nominal and real yields can tell us a lot about the mood of fixed income markets – and it's been souring since mid-March. US breakeven inflation rates have dropped by about 40 basis points. The 5Y5Y forward breakeven rate has, by my calculation, collapsed to 2.4% from more than 3% at the beginning of the year. That is particularly worrying as it signals a significant flattening of the breakeven curve.
Real rates have been selling off meaningfully faster than nominal. This gives me an uneasy sense of déjà-vu: almost exactly two years ago, I wrote of similarly "scary moves" in bond markets, arguing that, while one might expect real rates to sell-off in a bond-bearish, economy-bullish, QE-tapering scenario (because of the coupon-duration effect), it takes a genuine fear of disinflation for them to sell-off faster than nominals.
Maybe this is nothing more than a bunch of macro hedge funds getting caught on the wrong end of a mean-reversion in a relatively illiquid TIPS market. But if it is genuine disinflation fear, who could blame the markets? As well as rising unemployment, the latest US jobs numbers revealed stagnating wages and working hours, and manufacturing data has been awful in the US lately, and pretty bad worldwide.
Back in 2011, those scary moves precipitated a genuine market crisis that rumbled on until the Fed and ECB both responded in the autumn of 2012. Now, the danger is that markets recognise that the central banks understand their extraordinary policies have done little to get money moving through the real economy – just as we enter a downward lurch in global growth, earnings and profits, with widening credit spreads and rising defaults. Far from QE tapering and the end of the bond bull market, yields might just have hit their short-term highs, and may have yet to hit their all-time lows.