Why are Bonds Falling?
The outstanding features of the financial markets in recent weeks, especially in the US, have been that share prices are rising and bond prices are falling. Each of these phenomena on its own is subject to the usual debate as to what is causing it. But finding an explanation that fits both at the same time is more difficult.
Most analysts – including the mainstream ones working for big banks and investment houses, but especially the ones who think and work outside the consensus – believe that the key factor behind the ongoing rise in shares is the unprecedented liquidity being injected into the financial system by the central banks, including the Fed, the ECB and the Bank of Japan. There is even agreement that corporate ‘fundamentals’, meaning the level of earnings and expectations of future earnings, are not good enough to justify the ongoing uptrend – and, indeed, the most recent set of earnings has been generally disappointing. The macro-economic picture is also weak or, in the best interpretation, not strong.
But in that case, and given how low inflation rates are, bonds should still be in demand and their prices should be rising whilst their yields fall. Yet, for the last year, bond yields have been rising. To make matters worse, from an analytical point of view, government bond yields have risen sharply, despite the fact that the Fed is engaged in buying no less than$85bn every month of US Treasuries and mortgage debt issued by government agencies. This alone should have put a floor under bond prices and ensured that they would not fall.
Yet fall they have. The yield on 10-year US government bonds is currently around 2.7%, almost double the record-low level of 1.39% reached last summer. Thirty-year bond yields have risen even more and are now at 3.7%, which has fed through into a sharp rise in mortgage lending rates. That, in turn, has sent the demand for new mortgages plunging, and crushed the ‘refi’ market in which borrowers refinance their existing mortgage by taking out a new loan at a lower interest rate. These developments threaten to undermine the recovery in the housing market, which is a key component of the overall economic recovery which the Fed’s aggressive monetary policy is aimed at spurring.
However, there is a simple way to explain both rising share prices and falling bond prices. It’s called economic recovery. When an economy recovers from a recession, especially a deep and prolonged one, there is a stage in which the equity market does well – because the nascent recovery implies rising profits in the future, whilst bond prices fall because the recovery is expected to translate into stronger demand for loans – meaning higher interest rates – and also cause higher inflation, which is bad for fixed income securities, aka bonds.
In other words, if you believe that the US economy is now recovering and that growth is going to improve, so that loan demand rises and inflation too, then it all makes sense. Better still, the outlook is rosy and – at last – all will be well. The economic data released yesterday – or at least some of it – supports that view.
But not everyone is willing to buy into that happy tale. First of all, the recovery has supposedly been underway for four years, during most of which time bond prices fell, Secondly, as soon as the Fed hints that it may reduce its bond purchases, all the financial markets tank – suggesting that without the artificial support they are receiving from the Fed, they have no strength, and refuting the idea that they are responding to a recovery in the real economy. Furthermore, if rising interest rates threaten to choke off whatever recovery there is, then there can’t have been very much to start with.
There is a more ominous explanation of the phenomenon of rising interest rates. It says that rates are not rising because of an incipient recovery, but because lenders are getting increasingly worried about the ability of borrowers to pay. The underlying financial condition of cities and states in the US and of countries in Europe is, in a word, terrible, Detroit, as discussed here last week, is likely to be the first of many major cities to admit it cannot pays its debts, let alone meet the promises it extended to its employees for pensions and healthcare. This approach doesn’t attempt to reconcile the boom in the equity market – dismissed as “la-la-land” – with the decline in bond prices, seen as “reality”. It is greatly to be hoped that this is a mistaken view, but hope is not a sensible basis for making decisions.