Financial Services

The Recession of Bond Market has just Started

PRLog (Press Release)Jul. 8, 2013This has led to a destabilizing tendency to exit.  Decreasing bond price with rising long-term interest rates has weakened equity markets, especially for those firms which employ huge amount of debt financing.  The equity prices of them increases and this implies that their cost of capital has risen as well.

Most of the commentators complained that the reason for the increased interest rates or yields may be due to a minor fundamental change, in which developed economies remain inactive while the emerging economies that lead the global economy are continue growing.  Core inflation is being controlled and the commodity prices are becoming steady.  Many feared that currently the economy is somehow in the economic Groundhog Day where everyone expects faster economic activity and inflation that lead to the rise of yields till an extent that the recovery cannot exist, this in turn leading to a decrease of bond yields again.  It is so fluctuated that has always been dangerous for investors in bond markets despite the fact that the credit crisis has passed a long time ago.

This is what Japan is going through at the moment.  The strategy of export-led growth by a weaker yen may lead to its own destruction by raising the import-cost-

push inflation, which is not the kind of demand-push inflation that people want to happen.  Higher imported inflation will push up Japanese government bond yields and even modestly higher bond yields will sharply worsen Japan’s fiscal deficit because of a huge 225% debt-to-gross domestic product (GDP) ratio.  Thus, it will also lead to an increase of future tax rise expectations or spending cuts that will lessen the economic boost from higher exports.  It is so problematic that reformist administration of Prime Minister Shinzo Abe has tried to tackle it through a huge government bond buy-back operation.Yet, Japan is a special case.  Bond yields are being driven by expecting the structure of interest rates will revert to normal form emergency instead of rising inflation expectations.  Even after selling off, 10-year US treasury bond yields only rose just above 2.5%. It was the level of rates that could not be justified in the past and could only be maintained by Fed’s injection of $85 billion of bond purchases every month.  Without the bond purchases and policy interest rates rising one iota, the long-term interest rates will have to go up to reflect the normal conditions of risk and reward.  Assuming Fed can cap inflation at 2.5% and maintain the real economic growth at around 2-3%, the 10-year yields will be moving towards 4.5 with or without policy rates following suit.

Most importantly, it is not essential to believe that growth and inflation are rebounding or Fed is going to raise interest rates.  Or even to believe that the long-term yields will increase higher.  Markets rarely move to a new level and the rise in market interest rate could be fluctuated.  Yields can also be increased to an extent that they seem to have overshot so much for the bonds to be bought.  This is likely to be closer to 4.5% in the US than 2.5% and the reverberations of such a jump will be felt around the world.

Nursing heavy losses, bond investors are likely to play safe, pushing up the emerging market bond yields, steepening yield curves as well as pushing down the currencies of emerging market.

There will be a reversal of carry trades, many of which were funded in dollars and yen, propelling these two currencies upwards. While expecting the sustainment of the rise in bond yields, it is less certain of the rise in the dollar. Rising interest rates are generally seen as currency supportive, but it remains unknown that which market will overseas find attractive after the passing of risky trades.  A falling bond market, an under-pressure quity market or deposits with low-levels of interest rates?  Given the large deficit of US current account, the dollar needs net inward investment into dollars assets for it to stay still or rise.

Will rising bond yields in the US and around the world depress the nascent economic recovery and end the long equity market recovery?   Places outside Japan may not be the same.  The bank lending data tells us that the slow recovery has not been built on extravagant borrowing. It is due to reductions in real wages instead. Healthier corporate balance sheets have also numbed corporate conservatism, leading to a slow return of private sector investment.  And among all comments, in many cases including the US and most of the Europe, the government deficits have decreased, lessening investment-stalling fears of a euro break-up or US defaults. Bernanke’s announcement that he will be withdrawing the US economy’s addiction to Fed’s bond purchases will cause lose, but still we can survive. It does mean that the better investment opportunities are those that do not depend on very cheap debt finance.

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