World markets are at crunch point

Gary Duncan: Economic view

The earth moved in global financial markets at the end of last week. After March’s sharp tremors across the world’s stock markets, this time it was the turn of the bond markets to shake up investors.

There now seems little doubt that we are approaching a watershed at which global financial conditions, which have been remarkably benign for a protracted period, are shifting to a new and more unpredictable dynamic – one with far-reaching repercussions.

To many observers, the events in the second half of last week will seem arcane. A sudden spate of heavy selling of longer-dated, ten-year US Treasury notes, fostered in part by technical adjustments in the hedging of Americans’ mortgage debt, triggered an abrupt jump in benchmark US bond yields.

Yet far from being arcane or irrelevant, last week’s moves are almost certainly the precursors of a global sea-change in financial markets that will wipe out the key assumptions underpinning dozens of high-risk investment strategies, and undercut the financial logic behind at least some of the present wave of highly leveraged corporate mergers.

It was not merely the scale and speed of the shift in bond markets on Thursday and Friday that hinted at its significance, but also the shattering of an historic trend that embodied the recent, prolonged era of abundant capital and low volatility that has proved so fertile for markets, investors, speculators, and corporate players.

On Thursday, as an aggressive sell-off ripped through the US Treasury bond market, the yield on benchmark ten-year notes burst back above 5 per cent in its steepest daily move for two years. Then, on Friday, the ten-year yield came within a fraction of reaching the key threshold of 5.25 per cent.

Crucially, these moves brought to an end a two-decade-long pattern of the bull market in bonds in which successive peaks in ten-year yields have been progressively lower. For many in the markets, the breaching of the 20-year trend was a spine-tingling moment – and rightly so. At the same time, we also witnessed the apparent unwinding of the famous “conundrum” highlighted by Alan Greenspan, of the persistence of very low long-term market interest rates.

To understand the implications, we need to consider what was driving these events.

Despite widespread assertions to the contrary, this does not really seem to have been a sudden flap about inflation dangers. The shift that took place was concentrated in real bond yields, with index-linked bonds barely affected. In addition, the move was not accompanied by any parallel jump in gold prices, which is what would have been expected if this was an inflation scare.

Instead, there seem to be two more credible, principal explanations here. The first is that the Treasuries market finally cottoned on to the likelihood that, with somewhat better than previously anticipated prospects for American growth, the Federal Reserve will not be cutting US official interest rates any time soon.

The second factor is that this sudden leap in US market interest rates reflects the sharp, worldwide slowdown in the past, very rapid expansion of global liquidity as all of the world’s key central banks (besides the Fed) tighten the interest rate screws.

This second factor is one reason why the surge in US benchmark bond yields was mirrored in the British, continental European and Japanese government bonds markets, too.

Where, then, do we go next? In the short-run, as we report this morning, analysts expect a further bout of bond market turbulence driven by the shift in US rate expectations. So much seems inevitable – as does some spillover of increased volatility into other asset markets.

What is not clear is whether the upward march of benchmark yields, in the US at least, will prove a decisive trend. In America, significantly higher yields, if they do persist, probably contain the seeds of their own destruction. As this rise in market interest rates intensifies the squeeze on an already weakened US economy, markedly raising the cost of capital for borrowers, a deeper slowdown in American growth will ultimately trigger a fresh reappraisal of the growth outlook that will send yields lower once more.

More crucially, however, as the chart above from Deutsche Bank suggests, the worldwide retreat of the past few years’ hugely abundant supply of capital, as central banks pursue their present push to curb liquidity growth, is set to persist. And it is this decisive shift to tighter global financial conditions that seems set drastically to reshape the market and corporate landscape.

The benign constellation of financial trends that has fuelled a global boom in assets of all kinds for the past five years is now breaking down.

The past global glut of cheap capital created by low official interest rates flooded into every corner of financial markets. As prices rose, and returns were depressed, the much-vaunted “search for yield” encouraged moves into ever riskier assets and strategies in a hunt for enhanced performance.

Much of this is, if not quite over, now coming to an end. And the adjustment to a new era will bring casualties as speculators are wrong-footed and miscalculations are unmasked.

It is not all bad news. The still buoyant global growth outlook that provides the rationale for higher official interest rates means that there should be some significant support for equity markets. But share valuations, which have been boosted by the merger boom, are still likely to face a rigorous test, while many riskier, speculative plays in the markets may implode.

As dearer money raises financing costs, the viability of some leveraged buyouts is likely, too, to be called into question.

If you thought you heard a crunch just then, you probably weren’t mistaken.

gary.duncan@thetimes.co.uk

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