Writer’s Note: Yields on 10-year Treasuries have spiked in the recent days, now approaching the 3.00% mark. What does this mean? The Fed’s Quantitative Easing is no longer working. And when all else fails…well…you get a War. — LuciferBernanke
In my experience, markets don’t deal well with several crises emerging at the one time. Give them just QE tapering and they may be able to adapt, but throw Syria and an Asian currency mess into the mix, and it can make for a wild ride. Underlying all of the recent volatility though is the first sign that investors are starting to doubt the omnipresent powers of central bankers. Ben Bernanke says there can be QE tapering without rising interest rates and bond markets revolt against that idea. Similarly, the new Bank of England chief Mark Carney says interest rates will remain low for the next three years and bond yields jump given better economic data and rising inflation.
This is important because the mother of all bubbles in the modern era hasn’t been in subprime, bonds or emerging markets. No, the biggest bubble has been in central banking. It’s been a bubble based on faith in central bankers to provide cheap money to smooth out business cycles and prevent serious economic downturns. That faith has been unwavering despite the 2008 crisis and the tepid recovery since. Until now.
What does this mean for markets? Recent events may prove a prelude to the ultimate endgame: investors realizing that unwinding the extraordinary post-crisis policies will be messy, which gets priced into higher bond yields and exposes the vastly over-indebted developed world and some of the hot money reliant developing countries. I doubt this endgame is imminent though and oversold bond and emerging markets may be due for a bounce. The likes of India and Indonesia will be hoping that time is on their side so they can push through badly needed reforms which will them less exposed to a further crisis down the road.
What is it with summer holidays (for much of the world) and market turmoil? It seems like someone’s bad joke to give investors a headache while they’re trying to get some down-time.
Anyhow, markets are digesting a lot of actual and probable events right now. They’re looking at possible QE tapering, volatile bond markets, the potential for US intervention in Syria, the coming announcement of a new U.S. Fed Chairman and crumbling Asian currencies. Receiving less attention are a big German election this month and another soon-to-announced bailout package for Greece. That’s not to mention that China and Japan have quietened down of late, though if they don’t announce serious economic reforms soon, they’ll be back in the spotlight. And you can throw in September traditionally being a terrible month for stock markets.
The simple and logical explanation for much of the volatility stems from Ben Bernanke’s statement in May signalling a potential pullback from QE. Of course, QE – aka money printing - has been used to buy bonds and thereby suppress yields. The purpose of this has been to keep interest rates below the GDP rate, thereby reducing America’s large debt to GDP ratio, now at 105%. Also, QE has aimed to get investors to part with their cash, by offering pitiful rates, and to put that cash into risk assets such as stocks. With rising stock markets, this would induce the so-called wealth effect where people feel wealthier and start to spend again, which boosts GDP. So goes the theory anyway.
Unsurprisingly, Bernanke’s announcement resulted in bond investors heading for the exit doors. After all, QE had helped keep bond yields low and any cutbacks would mean less demand and higher yields. Subsequently, U.S. 10-year Treasury yields went from close to 1.6% in May to the current 2.78%. For bond markets, that’s a bloodbath.