Why gentlemen are selling bonds and equity across the world

The markets have bought only one part of the two-fold message from the Fed-that it will taper off bond buying. The second one-that it sees growth reviving-hasn't gone through.<br /><br />

Vivek Kaul June 25, 2013 13:17:48 IST
Why gentlemen are selling bonds and equity across the world

"Gentlemen prefer bonds" is an old bear market saying. It essentially refers to a scenario where investors sell out of the stock market and invest their money into bonds, particularly government bonds.

But we live in 'interesting' times where investors are selling out of both bond markets as well as stock markets. The yield or return on the 10-year American treasury bond rose to 2.66 percent on June 24, 2013. The treasury bond is a bond issued by the American government to finance its fiscal deficit. Fiscal deficit is the difference between what a government earns and what it spends.

Investors have been selling out on the American treasury bonds. When a spate of selling hits the bond market, bond prices fall. But the interest that the government pays on these bonds until they mature, continues to remain the same, thus pushing up the return or the yield to maturity for those investors who buy these bonds.

The return or the yield on the 10-year American treasury bond has gone up at a very fast rate since the beginning of May. As on May 1, 2013, the return stood at 1.64 percent. Since then it has jumped by more than 100 basis points (one basis point is equal to one hundredth of a percentage) to 2.66 percent.

Why gentlemen are selling bonds and equity across the world

Any fresh bonds issued by the American government to finance its fiscal deficit will have to match the current return on a 10-year American treasury bond

The first repercussion of this is that the borrowing cost of the American government will go up in the days to come. Any fresh bonds issued by the American government to finance its fiscal deficit will have to match the current return on a 10-year American treasury bond. In fact, between May 1 and June 24, the return on the 10-year American treasury bond has gone up from 1.64 percent to 2.66 percent. This is a rise of more than 62 percent, which will ultimately reflect in the borrowing costs of the American government.

But that is not the major reason for worry. The return on the 10-year American treasury acts as a benchmark for other interest rates, including those on home loans (or mortgages as they are called in the United States).

So if the return on the 10-year American treasury is going up, then the interest rates on all kinds of loans go up as well. This is because lending to the government is deemed to be the safest and hence returns on all kinds of other loans need to be higher than the return made on lending to the government.

This has led to the interest rate on the 30-year home loans rising by around 100 basis points (one basis point equals one hundredth of a percentage) to 4.4 percent, writes Mark Gongloff on The Huffington Post. This rise in interest rates means higher EMIs (equated monthly instalments) on home loans.

"It is the biggest single move in interest rates since at least 1962, according to Dan Greenhaus, chief global strategist at the New York brokerage firm BTIG," writes Gongloff.

A higher EMI could put the housing recovery in the United States in jeopardy and thus impact overall economic recovery as well. At higher interest rates people are less likely to borrow and buy homes. Less home buying could slow down the increase in home prices. As Gongloff points out "The surge in rates will likely squeeze mortgage refinancing and borrowing and could smother the recent rebound in the housing market, which has largely been driven by investors taking out cheap loans to buy cheap houses."

Home prices in the United States have gone up by nearly 10.9 percent between March 1, 2012 and March 1, 2013, as per the Case-Shiller 20 City Home Price Index. A demand for greater homes creates jobs in the real estate and ancillary sectors. And more homes are likely to be bought at low interest rates than higher.

Low interest rates also get the 'home equity' loans going. Home equity is the difference between the market price of a house and the home loan outstanding on it. American banks give loans against this equity. People are more likely to borrow against this equity when interest rates and EMIs are low.

In fact, extraction of home equity became a very important driver of consumption in the United States in the years running up to the financial crisis which started in September 2008. As is the case with any advanced economy, consumption formed a major portion of the US GDP. Home equity loans were used to buy SUVs, furniture, other consumer goods or simply to pay off the debt that accumulated on other expensive forms of borrowing like the credit card.

Charles R Morris writing in The Trillion Dollar Meltdown: Easy Money, High Rollers, And the Great Credit Crash explains this phenomenon: "Consumer spending jumped from a 1990s average of about 67% of GDP to 72% of GDP in early 2007. As Martin Feldstein, a former chairman of the Council of Economic Advisers, has pointed out, that increase was financed primarily by the withdrawal of $9 trillion in home equity."

Feldstein's study was carried out for the period between 1997 and 2006. Home equity supplied more than 6 percent of the disposable personal income of Americans between 2000-07, another study pointed out. In fact, by the first quarter of 2006, home equity extraction made up for nearly 10 percent of disposable personal income of Americans.

But this is possible only when interest rates are low. With returns on 10-year treasury bonds rising, the interest charged on home equity loans is likely to go up as well. Hence, this means that people are less likely to borrow against their home equity. Also, with home loans becoming expensive the price of real estate is unlikely to continue to go up at the same speed as it has in the recent past, because Americans will now buy fewer homes. If home prices don't rise, there is lesser home equity to extract. All this means less consumer spending which in turn will lead to slower economic growth.

The rise in bond yields or returns is essentially a reaction to the decision made by the Ben Bernanke-led Federal Reserve of the United States, the American central bank, to go slow on the money printing operations. The Federal Reserve has been printing $85 billion every month to buy both government and private sector bonds. By buying bonds it pumped the printed money into the American financial system. With enough money going around, the Federal Reserve managed to keep interest rates low encouraging people to borrow and spend.

But now it wants to change track. As Bernanke told the press on June 19, 2013 "If the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year...And if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around mid-year."

Bernanke further said that "in this scenario, when asset purchases ultimately come to an end, the unemployment rate would likely be in the vicinity of 7 percent, with solid economic growth supporting further job gains."

Hence, if economic growth in the United States continues, the Federal Reserve will gradually slowdown and finally stop money printing by the middle of next year.

The message that Bernanke wanted to give was two-fold. One, of course, was the fact that the Federal Reserve would "taper" its money printing operations in the days to come. But the other more important message was that the Federal Reserve felt that strong growth was "finally" returning to the American economy.

But the markets (particularly the bond market) have bought only one part of the two-fold message from the Federal Reserve. The growth message clearly hasn't gone through. The bond market has clearly come around to believe that the days of "easy money" will be soon coming to an end, as the Federal Reserve will stop its money printing operations.

This will lead to interest rates going up. Interest rates and bond prices share an inverse relationship. As interest rates go up, bond prices fall. And in the expectation of the interest rates going up and bond prices falling, investors are selling out bonds, and thus driving up interest rates. As The New York Times reports "A bond sell-off has been anticipated for years, given the long run of popularity that corporate and government bonds have enjoyed. But most strategists expected that investors would slowly transfer out of bonds, allowing interest rates to slowly drift up." That has clearly not happened.

In fact, Bernanke made it very clear that the Federal Reserve is only planning to slow down and stop future money printing. It has absolutely no plans of withdrawing the money that it has already printed and put into the financial system. Or as Bernanke put it "akin to letting up a bit on the gas pedal."

"Putting on the monetary brakes would entail selling bonds out of the Fed's portfolio, and that's not happening any time soon," Bernanke said.

But the bond market is already taking into account the Federal Reserve pumping out the money that it has printed and put into the financial system, in the days to come. As and when that happens, interest rates will rise sharply.

At a global level, it has meant a slowdown in the dollar carry trade. Interest rates on loans raised in dollars are going up, making it unviable for investors to borrow in dollars and go searching for high returns, all over the world. This has led to investors selling out from stock and bond markets across the world. And that is likely to continue in the days to come.

(Vivek Kaul is a writer. He tweets @kaul_vivek)

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