How A Small Rise In Bond Yields May Create A Financial Crisis

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How can a a small rise in bond yields scare policymakers so much?

Ned Davis Research estimates that a 2% yield in the US 10-year bond could lead the Nasdaq to fall 20%, and with it the entire stock market globally. A 2% yield can cause such disruption? How did we get to such a situation?

Central banks have artificially depressed sovereign bond yields for years. Now, a small rise in yields can cause a massive market slump that evolves into a financial crisis.

Quantitative easing was designed as a tool to provide liquidity to a scared market and benefit from exceptionally attractive valuations of the lowest-risk assets, sovereign bonds. Central banks would cut rates and purchase these high-quality, low-risk assets from banks, thus allowing financial entities to lend more to the businesses and families and strengthen confidence in the economy. Once financial conditions improved, central banks would reduce their balance sheet and normalize policy. This never happened.

Central banks started purchasing sovereign bonds at rock-bottom valuations and continued buying them when they went from being under-priced to massively overpriced, regardless of the state of the economy, maintaining purchases in growth periods. This led to the European Central Bank purchasing sovereign bonds even when governments were enjoying negative real and nominal yields in their issuances. Bond yields became so low that the gap between bond prices and the reality of risk and solvency of the issuer widened to extreme levels. Southern Europe sovereign bonds “traded” at all-time high prices and historic-low yields despite worsening deficits and weaker economic conditions.

The Federal Reserve did the same. Throughout the growth periods, Yellen and Powell continued with aggressive asset purchases and low rates, bringing the 10-year sovereign bond yield to an abnormal level for a growing or recovering economy.

What happens when the central bank makes the highest-quality and lowest-risk asset extremely expensive? That savers take more and more risk for lower yields in other assets and that the perception of risk is clouded, driving investors to take too much risk in equities and bonds because the central bank is manipulating the most important risk signal: rates.

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