Are you thinking what I’m thinking? There are plenty of worried-looking people wandering around in trading rooms this morning.
Let's face it. The financial well-being of most market participants is tied to equities and bonds going higher and this snap-back in prices is rattling nerves. Even Bill Gross, probably the world’s greatest living bond-market expert, said the 25-year bond bull market is over. He has effectively acknowledged that interest rates are set to continue rising over the next three to five years.
Well, I expect Mr Gross will continue to find fixed-income opportunities to invest in, but he may be a little wary around the Treasury market. There seem to be several arguments for this move in yields:
The U.S. is coming through this mid-cycle growth pause and there is no further subprime impact on the markets. Holders of U.S. Treasurys overseas -- especially the oil producers and Asian central banks -- are searching for higher yield and selling. The Fed is not going to cut rates and perhaps the next move will be higher.
Just picking up on point two, you are going to be hearing a lot about Sovereign Wealth Funds. The term is being used to describe the combined activities of central bankers and treasury departments of Asian and Mideast countries, supposedly searching for higher yields away from the dollar and Treasurys. If it is really happening -- in a meaningful way beyond one or two headlines -- surely there would be more evidence in the currency markets. We will wait and watch, but there doesn’t at this point seem to be a radical shift in trading levels for the dollar.
Looking at point on, if U.S. growth is set to improve then this should be good news for equities, at least for the continued good health of corporate earnings. Yes, much higher borrowing costs could remove the support of M&A and stem the use of speculative capital -- but probably not yet. Hard to argue that rates are restrictive on growth at these levels.
On point three, OK, the market view is changing. But the view seems to have shifted straight from cut to hike, passing 'hold' with barely a pause. There is the chance that a combination of some weakness in the U.S. economy, especially the property market, will stay the Fed’s hand. Aafter all, the U.S. property market is priced off the 10-year and global liquidity flowing from the East.
Reversion to the Mean
Investor’s mettle is being tested. First it was subprime, then the China market falls, now we have rising U.S. yields. Is this the big one? I am having trouble convincing myself it is. All participants are cognoscente of this fundamental market analytic of "reversion to the mean." Life has been good. All asset classes have enjoyed the flood of liquidity. Now the market is asking if nominal annual returns from equity are in the range 6% to 110% over the long run. How can we justify this extended bull market?
The same argument is being used for the bond bull market. But reversion to the mean is lazy analysis. I am not saying it is different this time, but globalization and the new areas of growth are changing the game. Is it heresy to suggest that growth in G3 economies may slow or be lackluster, but companies with an international business profile and operations in fast-growing emerging markets should continue to make good money. They should continue to tap into the pool of savings in these economies.
If it is over, I think we need to see confirmation in other areas. The yen has to start appreciating as punters bail out of the carry trade. Emerging market equities should be seeing more distress in this latest round of weakness Chinese markets have been OK.
Final point … fear is high. That is encouraging. Really nasty market collapses tend to occur when everybody is at their most bullish: remember 2000!
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