Fitch Ratings has warned that global bond markets face a rude shock as the US Federal Reserve jams on the brakes to avert overheating, with grave implications for inflated asset prices across the world.
Brian Coulton, the agency’s chief economist, said investors have underestimated the Fed’s determination to drain excess liquidity and prevent the inflation genie escaping from the bottle. It can no longer wait as White House fiscal stimulus drives a surge in late-cycle growth.
“When you listen to what Fed chairman Jay Powell is saying, you have to take him at his word,” Mr Coulton told The Daily Telegraph.
“We think there will be four more rate rises by the end of next year, and the markets have not got their arms around this.”
Mr Coulton warned of a “giant sucking sound” as the G4 central banks switch rapidly from quantitative easing to quantitative tightening.
The Fed, the European Central Bank, the Bank of Japan, and the Bank of England, have together injected an average of $US1.2 trillion ($A1.7trn) each year into the global financial system since 2009, distorting the credit and equity markets.
It peaked at $US1.7 trillion in 2016, dropped rapidly this year, and will fall to minus $US500 billion in 2019 as the ECB halts bond purchases and the Fed cuts its portfolio by $US50 billion a month.
“There is a shock coming’
“There is a shock coming,” said Mr Coulton. Yields on 10-year US Treasuries surged to a seven-year high of 3.22 per cent after Mr Powell said the US economy was firing on all cylinders and issued fire-breathing comments on interest rates.
“We may go past neutral,” he said. “But we’re a long way from neutral at this point.”
Pepperstone Group said a move of this size is a “very rare occurrence” for the US Treasury market. Contagion spread instantly through the global debt nexus.
German Bunds lurched higher, as did Japanese long bonds, with knock-on effects through corporate credit.
Mr Powell’s language suggest that Fed officials fear they may be falling behind the curve and will have to step up the pace of tightening. The ISM services index rose to an all-time high of 61.6 in September.
President’s Trump’s spending blitz on infrastructure has suddenly begun to flow through, at exactly the wrong moment in the economic cycle.
Christine Lagarde, the managing director of the International Monetary Fund, said surging yields were a “wake-up call” for over-leveraged companies and countries that depend on a constant inflow of foreign funds.
She said global debt had risen 60 per cent to $US182 trillion since the last financial crisis and this is likely to be tested. “The climate of the global economy is beginning to change,” she said.
US bond yields are rising fast across the “yield curve” of all maturities. This implies that “real” yields have suddenly become unhinged. This poses a threat to high-debt “zombie” companies that have been shielded by QE.
“It could be an issue for the eurozone periphery and for weaker emerging markets,” said Mr Coulton.
“Central banks have compressed spreads so much over the last few years, and now it is all going into reverse.”
The combination of a rising dollar and rising US rates is painful for those countries in Asia, Latin America, and Africa that have relied heavily on dollar debt.
Morgan Stanley’s emerging market index fell 2.7 per cent this week, led by the usual suspects of Turkey, Argentina, South Africa, and India. It has now given up all its gains of the last 17 months.
‘Real problem’ for equity markets
Nobody knows where the pain threshold lies as yields rise for US 10-year Treasuries, regarded as the benchmark price of global money.
Bob Baur from Principal Global said the danger point is near 3.5 per cent. “That’s going to be a real problem for stock markets.”
Bill Gross, the “bond king” at Janus Henderson, said an interaction of complex global forces is pushing yields higher.
A shift in what is known as the “cross currency basis” has lifted the currency hedging costs for European and Japanese investors that hold US bonds.
This makes it more attractive to repatriate the money, until US debts offers a better return. “Euroland, Japanese buyers have been priced out of market,” he tweeted.
Mr Coulton said the ECB’s bond tapering is now intruding with an extra kick. Much of Europe’s QE leaked into the US debt markets, holding down yields.
Soon this flow will be cut off entirely. Americans will have to pay a higher cost to finance Mr Trump’s deficits and their borrowing habits.
The wild card is how Japan’s $US3.4 trillion life insurers will react to higher hedging costs. This industry is a global colossus and can create ripple effects in the world financial system, though it is tracked only by specialists.
Daniel Sorid from Citigroup said 30-year Japanese yields are nearing 1 per cent. This threshold could cause a major shift in behaviour, perhaps as these companies adjust their portfolios before the new fiscal year in March.
What is clear is that the era of easy borrowing across the world is over. We will have to live within our means.