The end of the easy-money era rocks bond markets
The world’s most powerful central bank is about to find out how far it can squeeze financial markets before something breaks.
Struggling to tamp down the most pervasive inflation in decades, the Federal Reserve (Fed) delivered its biggest interest-rate increase since 2000 (+0.75%) while outlining a plan to begin unwinding trillions of dollars in asset purchases that have kept world markets brimming with cash since the 2020 crash. Its peers will soon follow suit. Already in 2022, more than 50 central banks have hiked
borrowing costs by a half-point or more in one go (see the chart). And Bloomberg Economics has estimated that policy makers in the Group of Seven countries from the European Central Bank to the Bank of Canada will shrink balance sheets by about $410 billion combined in the remainder of 2022.
Yet it all comes at one of the most precarious times in recent memory for the global economy. Russia’s war in Ukraine, and the bevy of sanctions that followed, have upended business. Supply chains that were disrupted by the pandemic have grown even tighter, causing chaos for companies lashed by soaring prices for everything from labor to commodities. The worry now is whether central banks can accomplish the high-wire act of weaning the financial system off unprecedented stimulus, without disrupting the flow of capital and tipping economies into recession.
While there is little sign of widespread stress yet, some barometers of cross-asset health are moving closer to the danger zone:
1. An upside-down bond market
Like it or not, the U.S. Treasury yield curve remains the top dog economic forecaster — even if the Fed’s bond-buying spree in the pandemic has distorted its message. In normal times, when the business cycle is in good health, the interest rate on debt maturing in, say, 10 years, will be higher than that on shorter-term securities as investors demand more compensation for the risk that inflation down the road will erode returns. If the opposite happens, meaning short-term rates are higher than the longer term, the foreboding dynamic is known as an inversion — signaling a bet that the central bank will eventually have to cut rates in order to salvage growth. While not every inversion in the yield curve has led to a downturn, prolonged distortions have become eerily accurate, especially when two of the most widely followed curves become inverted at the same time.
- Since the beginning of the 1990s, whenever yields on both 3-month Treasury bills and 2-year notes have risen above the rate on 10-year bonds, a recession has followed almost without fail within the next six to 18 months. It is a simplified measure — the most recent double inversion preceded a pandemic that no one saw coming — but big moves in yield curves have kept investors on edge recently (see the chart).
- In late March and the start of April, the gap between 2- and 10-year yields briefly inverted before normalizing, reflecting market angst that the Fed’s mission to aggressively tighten policy risks sparking a recession by ramping up the cost of money and thereby constraining consumer spending as well as business activity.
- At the same time, the spread between the 3-month Treasury bill and the 10-year yield has been heading in the opposite direction, suggesting a still-healthy outlook for U.S. investment and consumption that gives the central bank room to make good on its policy-tightening plan.
- For now, yield-curve worriers are easy to find as the end of the easy-money era rocks global markets. Already this year, the Nasdaq 100 index of technology shares has had the worst start in decades, speculative stock strategies have lost billions and cross-asset volatility has spiked all over the world.
2. Disruption to the flow of credit
Companies have lost their ability to borrow money at ultra-cheap rates, a direct function of the central banks’ mission to cool the red-hot business cycle that has stoked inflation for everything, everywhere all at once. But when borrowing costs surge too far, too fast, the flow of corporate credit can become disrupted or even blocked entirely. In extreme instances, healthy companies can lose access to funding, wreaking economic havoc. This happened most recently during the onset of the pandemic, which forced central banks to take unprecedented action to keep corporate afloat. The most widely followed credit gauge is the additional yield (or spread) over sovereign bonds that investors demand to hold debt from the largest and strongest corporations. Currently, the spread on a Bloomberg index of world investment-grade corporate bonds has risen to 1.3%, from as low as 0.8% in June 2021, signaling higher borrowing costs. When the spread rises above 1.5%, it is a warning sign that credit markets could seize up, making borrowing a lot harder. The metric has proved a reliable red flag in the past after crossing 2% in the volatile years after the global financial crisis and during the pandemic fallout.
3. Short–term money markets crack
The Fed’s massive pandemic stimulus program caused excess liquidity in the financial system to balloon, with banks flush with record cash in the form of reserves. Now, as the monetary authority begins to pare a $9 trillion balance sheet, a process known as quantitative tightening, investors are on high alert for any resulting logjams in the financial plumbing. When the Fed starts to shrink asset holdings — by simply not replacing maturing securities — there will be an increase in the number of Treasuries and mortgage bonds in search of a home in the private sector. And the amount of reserves held in the banking system will fall by design. No one knows how any of this will ultimately play out. But the last time the central bank embarked on quantitative tightening, bad things eventually happened in late 2019. Banks saw their reserves fall sharply — fueling a disruptive spike in interest rates on so-called repurchase agreements, a keystone of short-term funding markets. That caused liquidity headaches all around and forced the central bank to intervene in the funding markets. The Fed has since implemented additional tools to help reduce these liquidity risks. But all bets are off. Some two and half years ago, total reserves held by depository institutions at the Fed slid to around $1.4 trillion (see the chart). That was enough to cause liquidity issues in overnight lending, even though banks at the time considered $700 billion as the lowest threshold for comfort. This time round, Barclays estimates the tipping point at some $2 trillion versus $3.3 trillion currently. All this is guesswork with few historic precedents, so the reserve level will be a key focus for risk watchers well before it hits this point.
All in, investors around the world are bracing for a disruptive tightening in financial conditions on multiple fronts, from bonds and credit to money markets, as central banks spoon-feeds markets with liquidity no longer. The Fed has never been able to reduce inflation by more than 2% in the U.S. historically without inducing recession. It is going to be really hard for the Fed to maneuver into a soft landing. In this context, investors looking to protect themselves against more market turmoil could start to be less negative about “blue chip” bonds as yields on investment-grade bonds (sovereign and credit) average now 2.8%, compared with an average dividend yield of about 2.2% for stocks in the MSCI World All Countries index. The current gap between the two yields, of about 0.6%, is the widest since 2011! In the US, where the rate hike is the strongest, the gap (2%) is even wider! This should be welcomed by investors reeling from the worst drawdown for global bonds (-12%) since at least 1973 as the worst of the historic rout is likely over. Having a bit more duration – investment grade bonds have a higher duration than high yield bonds – as a hedge in a portfolio is becoming more important as the risk of a slowdown in the economy is likely…