Bond Market’s $5 Trillion Antidote to Higher Interest Rates

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If you’re worried the Federal Reserve will topple the debt markets, consider this: there’s rarely been so much cash available in the world to buy assets such as bonds.

While the prospect of higher U.S. interest rates sent bonds worldwide to the biggest-ever quarterly loss, JPMorgan Chase & Co. says the excess money in the global economy -- about $5 trillion -- will support demand and bolster asset prices. Since 1990, there have been four periods when households, companies and investors held such a surplus. Each time, markets rallied.

“The world is awash with unprecedented excess liquidity,” said Nikolaos Panigirtzoglou, a strategist at JPMorgan, the top-ranked firm for U.S. fixed-income research by Institutional Investor magazine. “Fed tightening won’t change that.”

The cash cushion has surged in recent years as the world’s central banks injected trillions of dollars into the financial system to jump-start demand after the credit crisis. Now all the extra money that’s sloshing around may help extend the three-decade bull market in bonds even as a stronger U.S. economy pushes the Fed closer to boosting rates from rock-bottom levels.

Bonds suffered a setback last quarter as signs of inflation in both the U.S. and Europe sparked an exodus after yields fell to historical lows. They lost 2.23 percent, the most since at least 1996, index data compiled by Bank of America Corp. show.

Greece Crisis

This month, worries over Greece’s financial ruin and China’s stock-market meltdown have pushed investors back into the safety of debt securities. Yet Wall Street is still bracing for a selloff, especially in U.S. Treasuries, once the Fed moves to raise rates that it’s held near zero since 2008.

The U.S. 10-year note, the benchmark used to determine borrowing costs for governments, businesses and consumers, yielded 2.46 percent as of 8 a.m. on Monday in New York. Forecasters surveyed by Bloomberg say the yield will approach 3 percent within a year.

Although JPMorgan provided plenty of caveats, the company’s analysis suggests it might not play out that way.

Helped by bond-buying stimulus in the U.S., Japan and Europe, and increased bank lending in emerging markets, the amount of cash in circulation now totals $67 trillion globally, compared with about $62 trillion of estimated demand, data compiled by the New York-based bank show.

That happens when the amount of money in the world exceeds the value of the global economy, financial assets and the cash that individuals hoard in response to risk.

‘Not Worried’

While the surplus has fallen from a record $7 trillion in July last year, it’s still more pronounced than the three prior periods -- 1990-1995, 2002-2004 and mid-2009 to mid-2010 -- when cash was abundant and asset prices soared.

And if you compare that amount to the market value of bonds and stocks, the ratio is still well above pre-crisis levels.

“We’re not worried about the end of the bull market,” said Ashish Shah, the global head of credit strategies at AllianceBernstein Holding LP, which oversees $500 billion. “There’s good liquidity overall that needs to be put to work.”

One reason for the bullishness is that the U.S. economy isn’t generating the kind of wage growth and inflation that would lead investors to abandon bonds, even as hiring increases and business confidence grows.

Average hourly earnings stagnated in June, while consumer prices have fallen or remained flat every month this year. And bond traders are pricing in the likelihood that inflation will stay stubbornly below the Fed’s own 2 percent target through the end of the decade, data compiled by Bloomberg show.

Rate Expectations

Europe is struggling to boost growth and inflation, while the International Monetary Fund warned this month that financial-market turbulence from China to Greece poses a risk to global growth.

That means the Fed can be patient when it comes to rates. Although policy makers said at the Fed’s June meeting that the U.S. economy is getting strong enough to boost rates sometime this year, they’ve cut their forecasts for how high they need to go next year by a quarter point to 1.625 percent.

“Traders, investors and fund managers are unlikely to fall off their chairs” by the Fed’s rate increases, said Jim Leaviss, a London-based money manager at M&G Investments, which oversees $400 billion. “If you want to get really bearish on bonds, you will have to start thinking about yields and Fed funds rate going back to similar levels they were pre-crisis, but that’s unlikely to be the case.”

Before the financial crisis, rates exceeded 5 percent.

More Pain

Yet with yields still so low, bonds won’t provide enough compensation for investors as the economy accelerates and the Fed starts raising rates, no matter how much excess liquidity there is, according to William O’Donnell, the head U.S. government-bond strategist at RBS Securities Inc.

“These yields don’t fit the tableau of an economy that’s rebounding,” he said from Stamford, Connecticut.

Even if all that cash helps support bond prices now, it may ultimately increase the risk of bubbles and cause more pain later, said Kathleen Brooks, the London-based European research director at Gain Capital Holdings Inc.

Such liquidity can “trigger unsustainable rallies in asset prices and sow the seeds of the next crisis,” she said.

Regardless of what happens in the near term, DA Davidson & Co.’s Sharon Stark says the growing number of retirees and pension funds seeking steady, low-risk income will underpin debt demand worldwide for years to come.

And that comes as investors face a shortfall of bond supply of about $400 billion this year as central banks in Europe and Japan step up their quantitative easing.

“The amount of cash available to be invested is still pretty significant and that doesn’t change whether or not the Fed raises rates,” Stark, DA Davidson’s fixed-income strategist, said from St. Petersburg, Florida. “Yields are likely to stay low for a longer period of time.”

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