FTSE suffers worst day in months over bond fears
Tim Wallace THE FTSE 100 suffered its worst day since October as global jitters over a sell-off in bonds hit London, with traders fearful of a spike in inflation.
The blue-chip index snapped three straight weeks of gains as it fell 2.5pc yesterday, or 170 points, to below 6,500 for the first time since the start of the month. It tracked falls in Asia and Europe, faring worse than its counterparts on the Continent. The benchmark fell 2.1pc on the week, losing momentum after a record start to the year.
Andy Haldane, chief economist for the Bank of England, said central banks must keep a close eye on inflation or risk letting prices surge as economies burst out of London. A “resurgent demand” could pressure Covid-hit economies’ shrunken capacity, forcing up inflation, he said. Mr Haldane called inflation a “tiger [that] has been stirred by the extraordinary events and policy actions of the past 12 months”.
US 10-year Treasuries reached a oneyear high earlier this week.
‘The American economy can perhaps handle higher rates. Europe is infinitely more vulnerable’
‘The era of free money is over and we cannot entirely conjure away the costs of the pandemic as if it never happened’
Wild moves in the $21 trillion US Treasury market have become disorderly. Shockwaves are pulsating through the international financial system and threaten to snuff out Europe’s economic recovery before it has even begun.
Central bankers have long been fretting over what might happen if incipient inflation and gargantuan debt issuance starts to set off an exodus from global bond funds. They had their first real taste late on Thursday. The implied cost of borrowing rocketed for much of the world economy.
The US Federal Reserve must navigate a narrow strait between the opposite perils of Scylla and Charybdis: damned if it does nothing, and allows the turmoil to continue; but equally damned if it capitulates again, opts for easy stimulus to suppress yields and falls further behind the curve (in the eyes of bond vigilantes).
As matters now stand, the Fed has lost control over US monetary policy. Investors are betting that the overhang of excess M3 money created since Covid-19 began will combine with the Biden administration’s war economy stimulus – 13pc of GDP, including the pre-christmas package – to lift the economy rapidly out of its malaise.
Rightly or wrongly, they are pulling forward an inflationary implication. Futures markets have priced in a full rate rise in 2022 and two more rises in 2023. This is self-fulfilling and will soon start rippling through financial contracts unless corrected.
Put another way, bond traders are dictating policy. They are tightening long before the Fed thinks the coast is clear. So much for the charming idea of “running the economy hot”.
Thursday’s Nasdaq bloodbath was a sight to behold. Ark Invest, the momentum ETF, is down 18pc over two days and fast becoming a systemic threat in its own right, epicentre of a nexus of leverage. Saxo Bank warned that the “Tesla-bitcoin-ark risk cluster” could set off a toxic feedback loop that sucks other interlinked tech stocks into a downward vortex.
Krishna Guha from Evercore ISI said the Fed leadership was itself partly responsible for the mess. Insouciant language by key officials in recent days has been taken by markets as a “green light to ramp real yields higher”.
Jay Powell, the Fed chairman, misread the mood this week when he stated “rates are moving up because of confidence among markets that we will have a complete recovery”. He seemed to be endorsing it.
Mr Powell is right, in a sense. There has been a flow of good data this week. Durables orders rose 3.4pc in January and the jobs figures were better than expected. “It was the nail in the coffin. Investors dropped their sovereign bond holdings like a hot potato,” said Ipek Ozkardeskaya from Swissquote.
But if a gentle rate rise is healthy, a sudden rise is disruptive. Five-year US Treasury yields – the benchmark price of money for corporate bond issuance across the world – jumped 20 basis points in intraday trading on Thursday.
This amounts to a stress test for a financial system that has never been so leveraged to even minor moves in borrowing costs. Pandemic bailouts have pushed global debt to a peak of 355pc of GDP (IIF data). Offshore debt has jumped to $12 trillion. Emerging markets have borrowed exuberantly in a currency beyond their control.
The American economy can perhaps handle higher rates. Europe is infinitely more vulnerable. It has suffered deeper structural damage from Covid and it will take longer to recover due to the glacial vaccine rollout.
“We do not expect eurozone GDP to recover to pre-covid-19 levels until mid-2022, nine to 12 months later than in the US,” said Chiara Cremonese from Unicredit. “A tightening of financing conditions would risk delaying the recovery further.
But tightening is what Europe is getting. Eurozone bond markets did not import the effect of rising yields from the Trump reflation episode after 2016. German 10-year bunds remained well-behaved and even moved slightly in the opposite direction, taking its EMU satellites with it.
This time the contagion has been instant. The rise in real bund yields has tracked two thirds of the rise in real US Treasury yields. The European Central Bank’s Christine Lagarde and other key figures have been issuing louder warnings but so far they have been unable to shield the bloc from fallout.
The ECB still has almost €1 trillion left in its pandemic QE fund. Some of this could, in theory, be deployed fast. The problem is that inflation is roaring back in Germany. Economists insist that this is a temporary distortion but convincing German politicians and commentators is another matter.
The greater the scale of QE bond purchases today, the greater difficulties faced by the ECB system tomorrow if inflation ever does return in earnest. National central banks will start to lose money on their bond holdings. At some point they will be rendered technically insolvent and may have to be recapitalised by taxpayers. This is a political minefield.
This week’s scare is probably no more than a warning tremor as markets adjust to reflation. Emmanuel Cau from Barclays says it is a chance to buy the dip since earnings are beating estimates on both sides of the Atlantic, and funds will migrate from bonds into equities over time. “The taper tantrum episode of 2013 ended up offering a great entry point,” he said.
However, the era of free money is over and we cannot entirely conjure away the costs of the pandemic as if it never happened. The era of the ever-potent central bank bazooka is also over. It was easy to keep printing money or to go deeper into negative rates when the world was in deflation. Whenever there was a market tantrum, the Fed was each time able to reverse course and avert a serious crisis. The markets never complained.
Today, the Fed has to tread a narrower path. The Bank for International Settlements warned long ago that central banks were sliding ever deeper into a “debt trap”. These concerns were invariably brushed aside as a problem for the future. That future has arrived.