The World's Bond Vigilantes Are Back in the Saddle
Pity the poor pension fund manager. Toward the end of October, there was finally a chance to add some yield to a European fixed-income portfolio by lending money to Austria for 70 years at a yield of 1.53 percent. The sale raised 2 billion euros ($2.2 billion); it could have fetched more than six times as much, given the investor demand at the time of the sale. The securities were sold at a mild discount of 98.7 euros for every 100 euros of bonds. But if you sold your 70-year Austria bonds today, you'd immediately book a capital loss of almost 10 percent; less than two weeks after you took delivery, the bonds are now worth about 89 euros.
After spending much of this decade heading in one direction (and much of the second half of this year doing nothing), government bonds have changed course. Prices are falling, yields are rising, and market commentators are scrambling to make sense of the change in environment:
To capture the violence of the move in the past few days, consider the surge in the 30-year Treasury yield, which has climbed above 3 percent for the first time since the very beginning of the year -- a big step from its July low of more than 2 percent. Mathematically, it's a move of more than 2 standard deviations, as shown by the blue cloud in this chart:
The most popular theory for rising yields is that we're witnessing a reflation trade. The arrival of Donald Trump reinforces expectations for more fiscal spending, the argument goes, which in turn will stoke an inflationary backdrop that was already showing signs of life after several years of dormant prices. With the U.K. also expected to attempt a fiscal reset, and headline inflation in the euro zone reaching its highest level since mid-2014 last month, rising yields may signal nothing more (and nothing less) than the dissolution of deflation fears.
There's now a 92 percent chance of the Federal Reserve raising interest rates at its next meeting in a month's time, according to the futures market, up from 84 percent just prior to the U.S. election and 40 percent at the mid-year point. That's a pretty strong signal that investors are convinced that the Fed is convinced it needs to apply the monetary brakes to avoid an overheating economy.
So it would appear that the bond vigilantes -- to use the phrase coined by economist Ed Yardeni in the early 1980s to describe investors who seek to enforce economic discipline via their bond allocations -- have saddled up after years of inactivity. The U.S. government's average 10-year funding cost was 6.7 percent in the 1990s and 4.5 percent in the following decade. In the first half of this decade, it averaged 2.5 percent, and in the first half of this year 1.8 percent.
If the economic outlook and the prospects for averting deflation really have improved, it won't be clear for months what yield level this posse judges to be appropriate. It seems likely, however, that the era of negative yields we've recently lived through in many parts of the bond market is dying. The investment community will not mourn its passing.
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