The global deflation trade is unwinding with a vengeance. Yields on 10-year Bunds blew through 1 percent this week, spearheading a violent repricing of credit across the world\’s economic climate.
The scale is beginning to match the “taper tantrum” of mid-2013, when the US Federal Reserve issued its first gentle warning that quantitative easing wouldn\’t last forever, which the long-feared inflection point was nearing in the international monetary cycle.
This is shaping as the worst quarter for sovereign bonds in almost 3 decades.
The Bank of America Merrill Lynch Global Government Index is down 2.9 per cent since the end of March. Whether it holds, it\’ll be the biggest quarterly loss since the third quarter of 1987.
Paper losses in the last three months have reached $1.2 trillion. Yields have jumped by 175 basis points in Indonesia, 160 in Nigeria, 150 in Turkey, 130 in Mexico and 80 in Australia.
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The epicentre may be the eurozone. Bund yields hit 1.05 percent Wednesday in wild trading, up 100 basis points since March. French, Italian and Spanish yields have moved in lockstep.
A parallel drama is unfolding in the usa, where the giant bond fund Pimco slashed its holdings people debt to 8.5 percent of total assets in May, from 23.4 percent a month earlier. This sort of move in the fixed income world is exceedingly rare.
The 10-year US Treasury yield – the worldwide benchmark price of money – has jumped 48 suggests 2.47 per cent in eight trading sessions. “It is capitulation out there, and a lot of pain,” said Marc Ostwald from ADM.
The bond crash has been an accident waiting to happen. Money supply aggregates have been surging for months in Europe and the U.S., setting a trap for a small army of hedge funds trying to squeeze several last drops out of a spent deflation trade. “We were too dogmatic,” confessed one trader at RBS.
Gabriel Stein, at Oxford Economics, said “narrow” M1 money in the eurozone continues to be growing for a price of 16.2 percent (annualized) over the past six months. Broader M3 money has been rising in an 8.4 percent rate on a single measure, a pace not seen since 2008.
Economic historians will one day ask the way it was feasible for 2 trillion euros of eurozone bonds – another of the government bond market – to have been trading at negative yields in early spring of 2015 even while the reflation hammer had been coming down with crushing force.
“It was the greater fool theory. They always thought there\’d be some other sucker to purchase at an even high price. Now we\’re returning to sanity,” said Mr Stein.
M3 growth in the U.S. has been running in an 8 per cent rate this year, roughly in line with post-war averages. The economy has weathered the strong dollar shock and seems to have shaken off a four-month mystery malaise earlier this year. It created 280,000 jobs in May. Bank of America\’s GDP “tracker” is running in a 2.9 per cent rate this quarter.
Bond vigilantes, designed to have a sixth sense for inflation, strangely missed this money surge on both sides of the Atlantic. Yet M1 is usually a six-month leading indicator, and M3 flags inflation and growth a year ahead. The monetary mechanisms may be damaged but it would be courting fate to assume that they have divided altogether.
Jefferies is pencilling in a headline rate of 3 per cent through the fourth quarter as higher oil prices feed through. If it is right, we will be facing a radically different economic landscape within 6 months.
It has plainly been a bond market bubble, one that is unwinding with particular ferocity because new rules have driven market-makers out of the business and caused liquidity to evaporate. Funds thought they were on to a one-way bet because the European Central Bank launched quantitative easing, buying 60 billion euros of eurozone bonds every month. They expected Bunds to vanish from the market as Berlin increased its budget surplus to 18 billion euros this season and retired debt.
Instead they\’ve discovered that the reflationary lift from QE overwhelms the “scarcity effect” on bonds.
The ECB\’s Mario Draghi has achieved his objective. He has (for now) defeated deflation in Europe. Red carpet years of fiscal overkill, monetary contraction and an economic depression, the region is coming back again.
How this now unfolds for that world in general depends on the pace of tightening in the US. Futures contracts are still not pricing in a full rate increase in September. While the Fed is forecasting rates of just one.875 per cent late the coming year, markets are betting on 1.25 per cent, a brazenly defiant relocate a strange game of chicken.
The International Monetary Fund warns this mispricing is dangerous, fearing a “cascade of disruptive adjustments” once the Fed finally pulls the trigger.
Nobody knows what\’s going to happen when the spigot of cheap dollar liquidity is actually turned off. Dollar debts outside the U.S. have ballooned from US$2 trillion to $9 trillion in Fifteen years, leaving the planet more dollarized and much more vulnerable to Fed action than in the past.
Total debt has risen by 30 suggests a record 275 percent of GDP in the rich world since the Lehman crisis, and also to a record 180 per cent in emerging markets.
The pathologies of “secular stagnation” are still with us. China is still exporting excess capacity. The worldwide savings rates are still at an all-time high of 26per cent of GDP, alluding to same lack of spending that lies behind the Long Slump.
As Stephen King from HSBC wrote inside a poignant report – The planet Economy\’s Titanic Problem -we have used up our fiscal and monetary ammunition, and may face the next global economic downturn with no lifeboats.
The U.S. is probably strong enough to resist monetary tightening. It is less clear whether other medication is so resilient. The risk is that rising borrowing costs in america will set off an international margin call on dollar debtors – or perhaps a “super taper tantrum” as the IMF calls it – that short-circuits the fragile global recovery and ultimately ricochets back into the U.S. itself. In the end it could tip us all back into deflation.
“We in the Fed take the potential international implications in our policies seriously,” said Bill Dudley, head from the New York Fed.
Yet within the same speech six weeks ago also, he let slip that interest rates should be 3.5 percent once inflation returns to 2 per cent, a thought to ponder. Furthermore, he hinted that the Fed may opt for the fast tightening cycle from the mid-1990s, an episode that caught markets badly off-guard and resulted in the East Asia crisis.
This week\’s bond ructions are an early warning that it will not be easy to wean the planet off six years of zero rates, and dollar largesse on the scale never seen before. Central banks don\’t have any margin for error.