The Bond Market is Trying to Warn Us of Trouble

The benchmark 10-year U.S. Treasury yield hit a 10-month high on Jan. 10, 2018, trading at 2.59% for the first time since March 2017. It's not just the rise, but the speed of the rise that has investors agonizing that the bond market sell-off (bond prices are inversely correlated to yields) will turn into a fully fledge collapse with contagion of extreme proportions. 

Traditionally, higher yields correlate with a growing economy. However, post-Great Recession monetary policy threw all correlations out the window, and the recent surge in yields has nothing to do with an improving economy. It's more a pending problem.

The decade-long central bank gift of free money will eventually end, but the longer the handout remains, the more painful it will be when it is taken from under our feet; a day that may be sooner than many expect. Like a ball being held under water, the bond market is showing signs that the free lunch is over. 

The Bank of Japan recently announced it was to begin reducing its purchases of long-dated bonds, China has reportedly begun unloading its $3.1 trillion holding of U.S. Treasuries, and the Fed is beginning to unwind its balance sheet. Like a wave of money heading for the door, the bond market is cracking. (See also: Wall Street Exuberance May Signal Coming Bear Market)

*Source: FactSet

Who's to Blame?

Global quantitative easing topped $15 trillion after the financial crisis, which forced investors into low yielding bonds. In fact so low, that as of May 2017, according to Fitch Ratings there was more than $9 trillion in negative yielding debt -- debt that is guaranteed to lose money.

Reluctant to take their foot off the peddle, the Federal Reserve, the European Central Bank, and the Bank of Japan have kept a lid on yields, and the bond market rally intact. However, as chinks in the armor begin to form, central banks may have planted their own seeds of the next crisis. A crisis caused by central banks, and one that cannot be saved by central banks. 

Fallout 

If this sounds like just an issue for savvy bond investors, a potential fallout will affect more than just high flying money managers. Surging yields will increase borrowing costs, reducing capital expenditure, undoubtedly bringing to an end the decade-low unemployment rate. 

Furthermore, the great American dream will be put to the test for the second time this century. With over $10 trillion in mortgage debt, a sharp rise in yields will put pressure on mortgage borrowers. A potential chink in the employment market, coupled with an increase in mortgage payments -- a story all too familiar to middle-class Americans. 

The Bottom Line

In the wake of the financial crisis, long-term bond yields were pushed to levels not seen since the 13th century, according to Global Financial Data. Working out of the heavily accommodative financial world was never going to be easy. 

However, the length of the bond market rally made investors complacent, central banks too. The collapse of volatility was meant to be a good thing, but as Artemis Capital points out, it became a pricing tool. They [central banks] thought if volatility is low then the status quo will never be challenged. Why would it be? But now, as the bond market ball bubbles at the surface of chaos, volatility will be just another ball with only one way to go. 

"You can never destroy risk, only transmute it. All modern portfolio theory does is transfer price risk into hidden short correlation risk. There is nothing wrong with that, except for the fact it is not what many investors were told, or signed up for." - Artemis Capital.