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Bond Sell-Off Heightens Risk of '1994 Moment'

Monday, 10 Jun 2013 | 7:00 AM ET
Caroline Purser | Photographer's Choice | Getty Images

After months of speculation over the supposed "great rotation" out of fixed income into equities, bond markets are finally starting to show real signs of stress as they suffered their fourth-worst month in the last twenty years and yields rose in almost every major jurisdiction, moves which analysts have said could also pose a serious risk to equity markets.

Data from fund flow provider EPFR and Bank of America Merrill Lynch showed aggressive selling in the bond market, with BoAML's Global Bond Market Index falling 1.5 percent last month, its largest loss since April 2004. The dollar value of redemptions hit their highest level in 12 years over Fed tapering doubts, Mark Diver, analyst at Nomura pointed out.

(Read More: The 'Great Rotation'—Is It Finally Happening?)

The sell-off was particularly aggressive in the bond funds that invest in higher risk assets, with long term corporate, high yield and emerging market bond funds seeing particularly large outflows, Diver said on Monday.

Fund managers Steve Russell and Hamish Baillie at U.K. wealth and pension fund manager Ruffer, said the possibility of a "1994 moment" where investors lost money simultaneously in both equities and bonds as interest rates rose in response to a brightening economic picture was a "very real concern".

The Fed caught markets by surprise in 1994, when it raised interest rates for the first time in February. Stocks sold off for the next two months and bond yields jump.

"Gentlemen no longer prefer bonds, to judge by last month's events as bond markets suffered their fourth worst month in the last twenty years," Russell and Baillie said on Monday.

(Read More: Fed Exit Chatter Unlikely to 'Taper' Off With Jobs Data)

"Yields rose in every major jurisdiction, with the plucky exceptions of Portugal and Slovakia. Explanations given for such moves have been many and varied, but while hopes for better economic growth, especially in the U.S., might be part of them, a 'will they won't they?' debate around the U.S. Federal Reserve possibly tapering its asset purchase programme certainly played its part."

"It is one of the paradoxes that we all need reminding of that any improvement in economic news is likely to mean greater volatility and possibly downright declines in financial assets as investors extrapolate to a period of reduced stimulus from central banks," the pair added.

(Read More: Bond Sell-Off: Two Brokerages Face Off)

Societe Generale's Patrick Legland also noted that while the rise in bond yields is directly linked to the improvement in the U.S. economy, he warned the move could hit equity markets.

"Our strategists and economists reiterated their year-end target of 2.75 percent for U.S. rates. If this scenario materializes, equity markets could be at risk," Legland said.

"Indeed, five times in the past 30 years in the U.S., we experienced a rise of rates above 50 percent from their lows. On three occasions, this rate shock translated into an equity correction of between 15 percent and 45 percent. Therefore, a rise of US rates to 2.75 percent by year-end has a relatively high probability of hurting equity markets. The question for financial markets is: how far and how fast rates could rise without impacting equities," he added.

However, not everyone thinks that a "1994 moment is likely", and as Citi analysts led by Anna Esposito point out, after an initial drop, stocks entered a strong bull market for the rest of the decade.

"While it is interesting to step back in time and observe key periods in financial market history, we suspect that parallels between 1994 and now are overblown," said Esposito.

"Low inflation pressures should afford policy makers greater flexibility. Additionally, communication policy appears stronger now than 20 years ago," she added.

By CNBC's Jenny Cosgrave: Follow her on Twitter @jenny_cosgrave

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