The Bond Market Vigilantes Are Back?

Written by Paul Hodges

The bond market vigilantes are back - and they clearly don’t like what they are seeing.  That is the clear message from the charts below, showing movements in 10-year government bond interest rates for the major economies, plus their exchange rate against the US$ and the value of the US$ Index.

...The financial world has completely changed since the Brexit vote in June, and then Donald Trump’s election. The Brexit vote saw rates begin to surge and the US$ to rise; these moves have accelerated since Trump’s win.

(Click on image to enlarge)

Since the Brexit vote,

• U.S. rates have risen by more than a half from 1.4% to 2.3%;
• U.K. rates have trebled from 0.5% to 1.5%;
• Chinese rates have risen by more than a tenth from 2.6% to 2.9%;
• Japanese rates have risen from -0.3% to zero;
• German rates have risen from -0.2% to a positive 0.3%;
• Italian rates have doubled from 1% to 2%.

At the same time, the value of the US$ has been surging against all these currencies, as the black line in each chart above confirms, and the value of the US$ Index against the world’s major currencies has risen by 8% to $101.

The above are quite extraordinary moves, and it is most unlikely they will be quickly reversed.  They mark the start of the Great Reckoning for the failure of the stimulus packages introduced on an ever-larger scale over the past 15 years. Now investors are going to find out the hard way that return on capital is not the same as return of capital, due to the return of the bond market vigilantes...

The key issue is that the demographic dividend of the BabyBoomer-led SuperCycle is now creating a demand deficit.  The 50% rise in global life expectancy since 1950, combined with the 50% decline in fertility rates, means that we have effectively traded 10 years of increased life expectancy for economic growth.  That’s not a bad trade, and I have yet to meet anyone who would volunteer to die early, in order to allow growth to return.

The problem is that in recent years, policymakers have chosen to ignore these demographic realities.  They have instead assumed they can always create growth via stimulus programmes based on ever-increasing amounts of debt. Today, we therefore now face the problem of high debt ($199tn according to McKinsey, and 3x global GDP, last year), and no growth so...investors are now beginning to realise all this debt can never be repaid.

These developments also highlight how central banks are now starting to lose control of interest rates.  Instead, markets are beginning to rediscover their real role of price discovery based on supply/demand fundamentals.  They are no longer being overwhelmed by central bank liquidity:

• The interest rate rises will have major impact on individuals and companies, as prices realign with fundamentals;
• A rising dollar is also deflationary for the global economy, as it further reduces growth levels outside the USA.

As I warned last month in an article entitled Budgeting for the Great Reckoning:

“The problem, of course, is that it will take years to undo the damage that has been done. Stimulus policies have created highly dangerous bubbles in many financial markets, which may well burst before too long. They have also meant it is most unlikely that governments will be able to keep their pension promises, as I warned a year ago."

“It is still possible to hope that “something may turn up” to support “business as usual” budgets - but hope is not a strategy. Today’s economic problems are already creating political and social unrest and, unfortunately, the outlook for 2017 – 2019 is that the economic, political and social landscape will become ever more uncertain. I always prefer to be optimistic but I fear that this is one of those occasions when it is better to plan for the worst, even whilst hoping that it might not happen...."