The past few weeks have given us a hint of what might happen when the Federal Reserve starts to reverse its super-easy monetary policy. Expect turbulence in financial markets, especially for assets that have moved far above normal or reasonable valuations.
A return to normality eventually implies a benchmark 10-year Treasury yield of 4 percent or more. It won't happen all at once, but that's where we're heading. With yields at roughly 2.2 percent, there's a long way to go. This transition will mark a recovery of the equity culture and the cooling of investors' protracted love affair with bonds.
Because of this prospect, markets are sensitive to the merest whiff that Fed Chairman Ben S. Bernanke might be forced by colleagues on the Federal Open Market Committee to reduce the scale of quantitative easing. This nervousness has affected asset prices across the maturity spectrum, not just at the short end of the money market as you might expect.
To those of us who were paying attention back in 1994, it all seems quite familiar. Chairman Alan Greenspan had made it reasonably clear that the Fed was about to start raising rates. Even so, the news seemed to come as a shock. I remember being on a trip to Australia after the Fed made its move. From the scale of the sell-off in Australian bonds, you'd have thought an inflation panic was breaking out, or that the Fed had lost all credibility -- but no, it was simply that many people had invested heavily in Australian (and European and other developed-market) bonds to take advantage of the yield spread over U.S. Treasuries.
In recent years, the search for yield has gone wider and deeper. The resulting deviation from normal valuations has been amplified by the shift of pension funds and insurance companies out of equities into fashionable bonds, and by the lingering effects of the great financial crisis of 2008 and 2009. It seems inevitable that some version of the shock of 1994 is going to happen again.
Many policy makers will bore you endlessly with what they've learned from past mistakes, on their superior understanding of the hazards, their improved communication skills, and so forth. This time, they say, when the Fed and others make their move to withdraw monetary stimulus, the fallout will be nothing to worry about. The past few weeks say otherwise.
David Fuller's view The fear of having a market run away from us on the upside is only exceeded by the fear of being long and wrong. This is particularly true for short to medium-term funds managed on the basis of price momentum. They considerably amplify market swings in both directions.
We have seen it in Japan's Nikkei 225 (weekly & daily) over the last seven months. Many other markets have experienced somewhat less dramatic moves over the same period. The biggest change has been in perceptions and the resulting allocation of cash and leverage, rather than fundamentals.
However, if 'Abenomics' marks the beginning of a potentially significant change in Japan's disinflationary/deflationary fundamentals, which I maintain is more likely than not, then Japan will more than shrug off the recent setback which is now being called its statistical 'bear market'. Instead, this recent move to the downside will be seen as a reaction and consolidation within a medium to longer-term recovery. Interestingly, Japan's other indices such as TPX, TSE2 and TPNBNK did not extend their declines today. Nevertheless, closes above Tuesday's rally highs are required to indicate that these indices are now finding more than temporary support.
Regarding the headline question from Jim O'Neil's article above, Fed Chairman Bernanke is currently the most influential official in terms of market expectations. Therefore he certainly has the capacity to either reassure or frighten markets. However, some investors in US bonds have been quietly hoping that the US economy would not gain sustainable recovery traction anytime soon, despite help from the current QE programme.
Therefore, if the US economy continues its slow recovery, as I suspect, the Federal Reserve's Open Market Committee will begin to reduce QE and eventually phase out this programme. Bond investors and the Fed may hope that this will be an orderly, uneventful process but prior history and the nature of markets suggests otherwise. Meanwhile, the Merrill Lynch 10yr+ Total Return Index (monthly & weekly) is very close to slipping beneath its August 2012 low following this year's failed upward break. I do not think that has happened previously and it would be a bearish signal, providing further evidence that the secular bull market in US long-dated government bonds is over.