You know you’ve been kicking around the markets too long when you start hearing echoes of echoes. Last week’s downward lurch in the bond market was certainly a reminder of 2013’s Taper Tantrum. But for anyone whose memory stretches back to Nelson Mandela’s inauguration and Pulp Fiction, the more painful memory is 1994 - a year that older investors would prefer to forget.
The stomach-churning air-pocket in markets that year was what prompted James Carville, Bill Clinton’s political strategist, to say: ‘I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.’
Before we go there, let’s re-cap the events of last Thursday, as the bond vigilantes rode back into town. The yield on the US 10-year Treasury bond rose by around a quarter of a percentage point that day to exceed 1.5% for the first time in a year. That might not sound much, but with yields at historic lows it was a seismic shock. It was enough to send the Nasdaq index 3.5% lower, the worst day for tech stocks since October. Markets in Asia matched those falls. Intimidation.
There have been straws in the wind for a few weeks now. Everyone knows that the biggest double whammy of fiscal and monetary stimulus since the 1940s threatens a resurgence of inflation. We all know deep down that inflation is the only realistic way out from under the mountain of debt created since the financial crisis. What hasn’t been tested until now is the resolve of the US government and the Federal Reserve to keep on building back better with newly printed dollars under the cover of artificially low interest rates.
The reflation-trade that has fuelled the market recovery from last year’s pandemic plunge demands a continuation of negative real rates. In other words, interest rates must be kept below the rate of inflation to allow the economy to grow faster than the debt mountain. With Washington expected to have thrown US$7trn at the pandemic by the time we emerge, even a US$21trn economy needs to expand quickly to persuade the market that we are not sleep-walking into the mother of all debt crises. Fed chair Jay Powell is going to have to work hard to persuade the vigilantes that he really does have no intention of removing the punchbowl as the US economy runs hot and inflation picks up momentum.
Back in 2013, the then Fed chairman Ben Bernanke learned a painful lesson about how not to communicate an exit strategy from the super-easy QE policy that had worked too well since the financial crisis. The resulting market strop was called a tantrum for good reason. Bond yields rose by 1.5 percentage points in a matter of weeks as Bernanke mused that, at some point, the Fed would have to reduce, or ‘taper’, its asset purchases. Treasuries sold off, the dollar shot up, emerging market currencies crumbled, stocks fell.
Keep going back, to 1994, and old hands remember the roar of disbelief that echoed around the Salomon Brothers trading floor when the Fed unexpectedly raised interest rates in February. Then, as in 2013 and again today, investors had convinced themselves that interest rates would remain low. Understandably so - they had not risen for six years as the US central bank provided the conditions for recovery from the early 1990s recession.
But investors were wrong. The Fed kept tightening through 1994 as the US economy picked up momentum. More jobs had been created in 1993 than in the four previous years combined. The new trend of loading up on debt, especially in mortgage securities, left bond investors exposed to the Fed’s decision to draw a red line on inflation. Hedge funds collapsed. Orange County in California went bust. The rout in the bond market spilled over into the stock market.
What happens now will depend on the stand-off between the bond vigilantes and Mr Powell. Who will blink first? It will also depend on whether the inevitable return of some cyclical inflation, as pent-up consumer demand is unleashed, turns into something more entrenched. No-one knows the answer to this. The experience of Japan is that you can monetise debt to your heart’s content without stoking inflation. But it’s a brave bet that America is the new Japan.
What looks certain is that bond yields are pushing higher. What we don’t know is how far they will go and how quickly? It is the pace as much as the direction of travel that can unsettle markets. The same is true of inflation. It’s both the speed and scale that matters to investors.
History suggests that stock markets can take modest inflation, in the 2pc to 4pc range, in their stride. It is only above the top end of this band that valuations start to fall much. Within that range, shares can continue to bask in the glow of all that newly minted liquidity.
That is not to say, however, that investors can sit back and relax. The relative performance of different sectors and investment styles has been a consequence of a persistently low interest rate environment. The high valuations of steady growth stocks, like the technology giants that now dominate the US stock market, are only justified because low rates today mean investors are relaxed about paying up for earnings growth tomorrow.
The message from both 1994 and 2013 is that bond-market-fuelled squalls blow over in time. The vigilantes will ride out of town again. But the memory of their intimidation will linger. The shape of the market they leave behind - and its winners and losers - may be very different.
Tom Stevenson is an investment director at Fidelity International. The views are his own. He tweets at @tomstevenson63.
