Rates to rise in US as bond market rules the roost again
The sharp sell-off on Wall Street on Thursday night, which led that market into a technical correction and triggered swingeing losses around Asia on Friday, underscores the role the bond market will play in determining the fate of equities this year.
The S&P 500 closed down 3.8 per cent — its second-largest daily fall on record, by points — after what has been described as “weak” demand in an auction of 10-year Treasury notes saw yields rise (and, conversely, bond prices fall) across all durations.
The yield on 10-year Treasuries spiked 72 basis points to 2.83 per cent, only marginally lower than the 2.88 per cent yield on Monday amid the maelstrom that engulfed the sharemarket.
After nearly a decade where bond prices and yields were generally of little relevance to equity investors because central banks imposed ultra-low ceilings on them, suppressing volatility across both markets, bond markets are slowly regaining their independence.
Last October the US Federal Reserve Board finally began the unwinding of the legacy of its response to the financial crisis, the $US3.6 trillion ($4.63 trillion) purchases of US government debt securities and mortgage-backed securities via its three quantitative easing programs.
In a very structured program, broadcast well ahead of its starting point, the Fed stopped reinvesting some of the proceeds it received from maturing securities.
Initially the amount it held on to was $US6 billion a month of Treasury securities and $US4bn of mortgage-backed securities and government agency debt. Every three months, however, those amounts escalate by $US6bn for Treasuries and $US4bn for the other securities until the Fed is retaining $US30bn a month from maturing Treasuries and $US20bn a month from maturing mortgaged-backed and agency debt.
That means that the Fed will not reinvest about $US230bn of the $US425bn of the Treasuries it holds that will mature over the course of this year. The flip side of that, of course, is that private buyers will have to be found to replace the Fed as a source of demand for US government debt.
The steadily diminishing role of the Fed as the biggest source of demand for Treasuries — and the reduced impact of its purchases on the US yield curve — will withdraw liquidity from the US bond market and almost certainly flow through to the rates required to attract demand for new issues.
With the average maturity of the Fed’s holdings about six years, the US Treasury has had to change its financing strategy to reduce the amount of new longerterm debt it issues to avoid a severe steepening of the yield curve.
With the Fed both raising rates — five 25 basis point increases so far in this cycle and three more flagged for this year — and gradually scaling down its presence within the market, however, it is almost inevitable that rates will rise and that the yield curve will steepen as the term premium, long suppressed by the Fed’s asset-purchasing programs, re-emerges. (That premium should reflect the risks, including inflation, of holding longer-dated securities relative to the overnight cash rate).
The US Treasury is scheduled to tap the debt markets for a net $US955bn this year, an apparently huge increase on the $US520bn it raised in 2017 but one which is impacted by the Fed’s falling reinvestment. The Fed has purchased its securities separately to the auctions conducted by Treasury, so the size of the auctions has had to be increased to reflect its reduced demand.
Nevertheless, it is a very sizeable financing task at a moment when it’s not just the Fed moving to normalise monetary policy. The European Central Bank, having already heavily scaled back the size of its asset-purchasing program, is widely expected to halt it by the end of the year.
The major central banks, having spent the past nine years hosing financial markets with near costless liquidity, are slowly closing the spigots.
In the US, with solid economic growth and unemployment at levels reflecting an economy nearing its capacity, Donald Trump’s tax cuts for companies and higher net worth households are going to add something to the growth rate and the prospect of increased inflation.
US rates are a long way from their “normal” levels. Before the crisis started to emerge, in mid-2007, for instance, yields on the 10-year bond rate were above 5 per cent as, indeed, was the federal funds rate.
Whatever normal might look like over the next few years, US and eurozone rates are likely to be materially higher — in the absence of a recession or fresh crisis — by the time the Fed has finished its program of normalising US monetary policy than they are today.
That wouldn’t necessarily be bad for stocks — it would be a sign of growing economies — but it would see borrowing costs for companies and governments rise. To the extent that equity values have been inflated by the absence of investment alternatives, a rise in bond yields might also see the central bank-inflated element of the valuations evaporate.
The central point to take from this week’s skittishness in the US and other equity markets, however, is that it dawned on market participants that, after nearly a decade where central banks pursued strategies designed to encourage risk-taking and sought to spark some inflation, the Fed, at least, is now beginning to focus on more traditional priorities.
That has some potentially very unsettling implications for markets that, for near a decade, have had central bank safety nets beneath them and have become very comfortable in that knowledge.
Monday’s market implosion and the immediate response overnight to the lacklustre demand in an auction of Treasuries were tastes of what might happen if the normalisation of monetary policies and yield curves — the safety nets — happens faster than the markets have anticipated.