Epic global bond rout is a QE success story - but it won't last
The sudden surge in bond yields is a victory, a sign that markets are finally starting to believe that central banks have defeated deflation
By Ambrose Evans-Pritchard
9:00PM BST 13 May 2015
The simplest explanation is the best. "Frustra fit per plura quod potest fieri per pauciora."
John Williams, the once dovish head of the San Francisco Fed, told Yahoo! Finance on Tuesday that the US economy is "running a little bit hot". Rightly or wrongly, he chose to dismiss the economic relapse in the first quarter as a weather-blip. The world's monetary superpower is chomping at the bit.
Hedge funds were asking for trouble by driving yields on 10-year German Bunds to a historic low of 0.07pc in mid-April. Trouble is what they got. Three weeks later, Bunds are trading at 0.65pc. The paper losses across the spectrum of global bond markets is roughly half a trillion dollars.
Put another way, Bank of America says the €2.8 trillion of eurozone debt trading at negative yields has just shrunk to €2 trillion. It calls this a "positioning purge".
The mistake was to bet on an acute shortage of sovereign bonds once the European Central Bank launched its €60bn monthly blitz of quantitative easing. Bunds were thought to have a special "scarcity premium" since they are dying out. The German government is running a fiscal surplus of 0.5pc of GDP this year.
Markets ignored known evidence that bond yields rose by 80-120 basis points during the various bouts of QE in America, which is what one would expect as recovery builds and the risk of deflation abates.
Contrary to mythology, QE does not work by lowering bond rates. It works through a different mechanism: by causing banks to "create" money.
ECB president Mario Draghi has accomplished his first goal, even if he might silently be cursing the newfound strength of the euro.
The eurozone is clawing its way out of depression. The growth rate of nominal GDP growth has risen from 1.1pc at the start of the year to 1.5pc, subtly altering long-term debt dynamics for the crisis states of southern Europe. They are no longer quite so close to a debt-deflation t
The one-year "inflation swap rate" - measuring expectations - has jumped by almost 100 basis points since October in the eurozone. The five-year contracts are starting to catch up.
This is a short-term cyclical upswing. It does not in itself narrow Europe's North-South rift in competitiveness, and does not magically turn EMU into an optimal currency area. It does buy time.
Lack of liquidity in the dealing rooms for bonds has amplified the bond shock. Regulators might have displayed more common sense when they imposed tougher rules on market-makers, extinguishing half the business.
The energy rally has added a further electric charge, setting off what amounts to a reflation-panic. "The back-up in bond yields has become horribly correlated with crude prices," said Mark Ostwald from Monument.
This mini-boom in oil may, of course, fizzle as Brent crude nears a powerful technical barrier at around $70 a barrel, up more than 40pc from the lows in January. Barclays, Morgan Stanley and Deutsche Bank all warned this week that paper trades on the derivatives markets have moved far ahead of fundamentals, ignoring a glut of excess cargoes building in the Atlantic.
The International Energy Agency's oil market report warned that over-supply has reached 2.1m barrels-a-day (b/d). Iraq, Libya and Russia are all cranking up output, and Iran is waiting in the wings with an extra 400,000 b/d of quick supply if there is a nuclear deal. While US shale has "blinked", it has not capitulated.
The great question is how long a world economy can withstand a spike in bond yields before this sets off a chain of nasty consequences, and ultimately defeats itself.
"There comes a point when this is too fast and too vicious, and starts to hit growth and earnings. That is when we could get an equity sell off," said Andrew Roberts, head of European credit at RBS.
The world's pain threshold is surely lower than ever. Debt has risen by 30 percentage points of GDP since the last financial crisis, reaching a record 175pc in emerging markets and 275pc in the OECD club.
Rising rates this year have already caused the iTraxx crossover index of European corporate bonds to jump 40 basis points to 280. In the US, higher Treasury yields feed rapidly into the mortgage market through the "convexity trade". Fannie Mae's 30-year mortgage bonds have jumped 36 points to 2.94pc in three weeks.
"We think the next shoe to drop will be US corporate credit. A lot of companies are bringing forward bond issuance this summer in a rush to beat the Fed. This could create a supply glut and a vicious circle," he said.
Jan Loeys, from JP Morgan, advised clients this week to pull some money off the table, warning that "dark clouds are now rising" for global asset markets. The bank said productivity growth turned negative in the US and the world in the first quarter, a stunning development that implies a lower speed limit for economic growth.
It also implies a smaller US output gap than widely supposed, making it harder for the Fed to bide its time before raising rates. It is not a pretty picture for a stock market boom that is already long in the tooth, flattered by record margin debt.
Nor is it pretty for those emerging markets that drank deepest from the pool of cheap dollar liquidity during the QE era, racking up $4.5 trillion of dollar debt. They have enjoyed three reprieves from a hesitant Fed so far, and have not used the time well to build their defences. The International Monetary Fund fears a "super taper tantrum" if and when the Fed actually pulls the trigger.
My own fear is that the reflation trade will prove to be another false dawn, overwhelmed within a year or so by the post-Lehman malaise of excess global savings and chronic lack of demand.
China has hit the rocks. Urban fixed investment has collapsed to near zero. China's factory gate deflation is running at -4.6pc and the country is still transmitting the effects of this to the rest of the world through a flood of manufactured exports.
President Xi Jinping could at any time let rip with a fresh blast of credit. He has chosen not to do so, clearly judging that this would store up even greater trouble. The world will have to learn to live for a lot longer with a different kind of China: a post-bubble invalid nursing its wounds.
Historians may pinpoint April 20, 2015, as the last gasp of a 34-year bull market in global bonds that began under the Volcker Fed in the early 1980s, the final inflexion point after yields had fallen through the floor in this year's QE mania.
But don't bank on it. Albert Edwards, at Societe Generale, coined the term "Ice Age" long ago to describe this era of deflationary ascendancy. He is bracing for one final polar freeze before we all hyper-inflate our way out.