“We’ve intentionally blown the biggest government bond bubble in history,” confessed Andy Haldane, Executive Director of Financial Stability at the Bank of England, to Members of Parliament in London last week. The bursting of that bubble was a risk he felt “acutely,” he warned. There have already been “shades of that.” And he saw “a disorderly reversion in the yields of government bonds” as the “biggest risk to global financial stability.”
And “shades of that,” as Haldane put it with classic British humor, namely understatement, are visible everywhere.
Ten-year Treasury notes have been kicked down from their historic pedestal last July when some poor souls, blinded by the Fed’s halo of omnipotence and benevolence, bought them at a minuscule yield of 1.3%. For them, it’s been an ice-cold shower ever since. As Treasuries dropped, yields meandered upward in fits and starts. After a five-week jump from 1.88% in early May, they hit 2.29% on Tuesday last week – they’ve retreated to 2.19% since then. Now investors are wondering out loud what would happen if ten-year Treasury yields were to return to more normal levels of 4% or even 5%, dragging other long-term interest rates with them. They know what would happen: carnage!
Wholesale dumping of Treasuries by exasperated foreigners has already commenced. Private foreigners dumped $30.8 billion in Treasuries in April, an all-time record. Official holders got rid of $23.7 billion in long-term Treasury debt, the highest since November 2008, and $30.1 billion in short-term debt. Sell, sell, sell!
Bond fund redemptions spoke of fear and loathing: in the week ended June 12, investors yanked $14.5 billion out of Treasury bond funds, the second highest ever, beating the prior second-highest-ever outflow of $12.5 billion of the week before. They were inferior only to the October 2008 massacre as chaos descended upon financial markets. $27 billion in two weeks!
In lockstep, average 30-year fixed-rate mortgage rates jumped from 3.59% in early May to 4.15% last week. The mortgage refinancing bubble, by which banks have creamed off billions in fees, is imploding – the index has plunged 36% since early May. But home prices have risen as private-equity funds and investors have gobbled up single-family homes, hoping that they could rent them out [which turned out to be difficult]. These inflated prices are now colliding with rising mortgage rates – and with the possibility that hot money might dump empty homes while it still can. Which would make for one heck of an ugly dynamic.
In low quality debt, the carnage has been particularly nasty – though it’s just the beginning. Frantic investors went to chase after yield that the Fed, in its infinite wisdom, had deprived them of elsewhere, and they sank their teeth into junk bonds, and overpaid for them in an epic feeding frenzy, and drove yields down to ridiculous lows, below 5% for some, though these bonds promised a relatively high probability of default and loss of principal to their hapless holders.
The absurd magnitude of the bubble was so glaring that even Fed officials who caused it began to get concerned, in part because financial institutions were loading up on junk. But on May 9, the party stopped, and the gnashing of teeth started. Junk bonds plunged and yields skyrocketed, with the BofA Merrill Lynch High-Yield index jumping from 5.24% to 6.44% by Friday.
Emerging-market debt got slaughtered as well, particularly dollar and euro bonds issued by companies that do their business and earn their profits, if any, in now plunging local currencies that once had been hyped as a sure bet against the dollar. Hype dies quickly. Now these companies face the insurmountable task of having to spend ever more of their weakening local currency to service their debts. There will be defaults. Billions will go up in smoke. In anticipation, these now crappy but previously wondrous bonds have taken a hard beating of almost 8% in five weeks. Emerging-market bond funds were hit by $9 billion in redemptions last week, the third largest ever. And it too is just the beginning.
All because of a single word. To its immense credit, the Fed, with its money-printing and bond-buying binge that is continuing at $85 billion a month, has accomplished a unique feat: shifting the focus of financial markets away from awkward economic and business fundamentals to what the Fed will do next. It worked like a charm for years. But now, what the Fed will do next has been boiled down to a single innocuous-sounding word: “taper.”
The mere possibility that the Fed might “taper” its binge has pricked the most insane credit bubble mankind has ever seen. A “disorderly” implosion could take down some big banks, and as Haldane put it, pose the “biggest risk to global financial stability.” So the Fed is now trying to figure out how to exit from its reckless experiment without taking down any banks; more TBTF bank bailouts would be embarrassing. Investors have taken note. Seatbelts are being fastened, and the clicks can be heard around the world.