Will it be Different This Time?

On the 22nd of May, Ben Bernanke uttered a few words that sent markets worldwide roiling. Since then 10-year yields on both Treasuries and Gilts have risen over 40 bps, and nearly every sector of the bond market has taken a hit. At the same time, inflation expectations have fallen, pushing real yields up even further.

So what was it that he said? Was it that the Fed was changing course and starting to reverse quantitative easing? Was it that the Fed was planning to raise interest rates soon?

No, all he said was that – so long as the labour market continues to improve – the Fed may look to start to slow down the rate at which it has been buying bonds “in the next few meetings.”

Wednesday’s announcements have now shed more light on the Fed’s intentions, with Bernanke again reiterating the position that the Fed is likely to slow its bond-buying this year due to the strengthening US economy. After all, it has been buying bonds at a whopping rate of $85 billion per month. Surely there must be room for it to gradually reduce this figure, right? Not according to bond markets.

So what exactly are bond markets telling us?

First, the obvious message is that bond markets are hooked on central bank liquidity. Any sophisticated investor is already aware of this, but to see just how sensitive bond yields can be to even a hint of “tapering” is unnerving.

Second, with inflation expectations falling while nominal yields rise, bond markets are also telling us that economic growth has been, and will continue to be, driven by excessive liquidity in the market – the kind of liquidity that encourages investors to take irrational risk with their money.

This is perhaps the most interesting message, because it’s “damned if you do, damned if you don’t.” If the Fed continues its massive bond buying program, inevitably this will translate into inflation – and perhaps not the good kind that comes with growth. This surely will push up both nominal rates and inflation expectations. If the Fed does slow down (let’s not even talk about outright stopping or reversing) its bond buying program, then we are sure to see nominal rates shooting up – but perhaps with real yields rising less.

Finally, both in 1994 and in 2003, bond markets got caught off guard, and bond yields soared. There is no reason to believe that this will not happen again. While markets have made clear the potential dangers of owning long-dated bonds at current levels, many investors will still be caught off guard as various events lead to spikes in bond yields. After all, why should it be any different this time?