How Bad Will the “Bond Massacre” Get?

Worse “than the 1994 ‘Bond Massacre,'” with “sustained double-digit losses on bonds, subpar growth in developed markets, and balance sheet risks for banking systems….”

The backdrop: after 36 years of bond bull market, the amount of US bonds has ballooned to $47 trillion, up 24% from just ten years ago:

  • US Treasurys ($19.8 trillion),
  • Municipal bonds ($3.8 trillion)
  • Mortgage related bonds ($8.9 trillion)
  • Corporate bonds ($8.6 trillion)
  • Federal Agency bonds ($2 trillion)
  • Money Markets ($2.6 trillion)
  • Asset backed Securities ($1.3 trillion)

Bonds dwarfs the US stock market capitalization ($27 trillion). Bonds are a global phenomenon with even bigger bubbles elsewhere, particularly in NIRP countries, such as those in Europe, and in Japan. That’s why bonds matter. They’re enormous. And the damage they can do to investors is huge.

So how bad might the next bond bear market get? Paul Schmelzing, a visiting scholar at the Bank of England and an academic at Harvard where he concentrates on 20th century financial history, published an unpleasant scenario on the Bank of England’s blog. He doesn’t mince words:

[A]s rates reached their lowest level ever in 2016, investors rather worried about the “biggest bond market bubble in history” coming to a violent end. The sharp sell-off in global bonds following the US election seems to confirm their fears. Looking back over eight centuries of data, I find that the 2016 bull market was indeed one of the largest ever recorded. History suggests this reversal will be driven by inflation fundamentals, and leave investors worse off than the 1994 “bond massacre.”

To arrive at his conclusion, he classifies bond bear markets into three types:

  1. The inflation reversal of 1967-1971
  2. The sharp reversal or “Bond Massacre” of 1994
  3. The steepening yield curve or “value-at-risk shock” in Japan in 2003.

He explains that “historically, inflation acceleration has been a solid predictor of sharp bond selloffs.” But other “prominent episodes appear less correlated with fundamentals, and can inflict similar levels of losses.”

Type 1: The inflation reversal of 1967-1971 occurred as annual inflation shot from 1.6% to 5.9%, along with some pressures on the federal budget from the Vietnam War that pushed the deficit from 0.2% in 1965 to 2.8% in 1968. But even when the budget moved back into balance, Treasurys continued their rout:

The “inflation reversal” leaves bondholders particularly bruised, and is most clearly associated with fundamentals: namely a sharp turnaround in realized consumer price inflation (CPI).

Type 2: The Sharp Reversal of 1994, or the “Bond Massacre,” turned out to be short-lived. It wasn’t caused by inflation, fiscal policies, or Fed action. The Fed did begin to raise rates in May 1994, but the turmoil had started in Q3 1993 and peaked in early 1994. Instead:

[T]he dramatic increase in leveraged bond positions by both US hedge funds and mundane money managers set in motion self-reinforcing liquidations once uncertainty over emerging markets including Turkey, Venezuela, Mexico, and Malaysia – all of which experienced sharp capital flow volatility – put pressure on speculative positions.

Type 3: The value-at-risk (VAR) shock in Japan in 2003 occurred when fears spread that the Bank of Japan, which was already doing QE before it was called QE, would taper its purchases of Japanese Government Bonds. The yield curve, which had been extraordinarily flat, steepen sharply, as prices of longer-dated bonds sagged. These sagging prices hit banks, which hold large portfolios of JGBs, particularly hard. Their shares crashed to multi-year lows, and some received taxpayer bailouts:

[T]he sudden steepening of the JGB curve from the middle of 2003 posed a new set of challenges: calibrated risk management structures, known as “Value-at-Risk” models, required banks to shed JGB assets once their price started plummeting. Since most banks followed similar quantitative signals, and exerted a traditionally strong home bias in their fixed income portfolios, a concerted dumping of government bonds ensued.

Schmelzing concludes:

A pessimistic reader could certainly identify gloomy ingredients for the “perfect storm”: the potential for a painful steepening of bond curves, after a sustained flattening as in 2003, coupled with monetary tightening; and a multi-year period of sustained losses due to a structural return of inflation as in 1967.

But he considered the Type-2 “meltdown,” as it happened in 1994, less likely. At the time, highly leveraged bond positions and external shocks came together. This time, there has been “progress on bank leverage regulations,” and “the current global capital flow cycle has already almost fully reversed from the cycle peak,” he writes.

Instead, it will more likely turn into a toxic combination of Type-1 and Type-2 bear markets:

Global inflation dynamics are picking up, at a time when Central bankers voice more tolerance for “inflation overshoots.” Though currently bank equity investors are cheering the steepening of yield curves, meanwhile, the 2003 Japan episode should fix regulators’ attention on the growing home-bias in government bonds.

Banks in some countries are particularly exposed to the VAR shock, including Italy, whose financial institutions hold 18% of their assets in Italian government debt, up from 12% in 2008. And “in most geographies,” banks hold these domestic government bonds mainly in “‘available-for-sale’ portfolio buckets, where they have to be marked-to-market.” That allowed banks to take the gains as central banks pushed down interest rates and inflated bond prices in recent years, but it now exposes them to losses and forced selling.

On balance, then, more than to a 1994-style meltdown, fixed income assets seem about to be confronted with dynamics similar to the second half of the 1960s, coupled with complications of a 2003-style curve steepening. By historical standards, this implies sustained double-digit losses on bond holdings, subpar growth in developed markets, and balance sheet risks for banking systems with a large home bias.

And that would not conform to the rosy scenario.

President-Elect Trump has been hounding certain companies with his drive-by tweets, to knock them around some, get their shares to sink, and cut some “deals.” And companies react. But there’s more to it than what’s on the surface. Read… Trump Tweets, Ford & GM Counter, their Shares Jump, the Peso Plunges, but the Jobs Won’t “Come Back” to the USA

Enjoy reading WOLF STREET and want to support it? You can donate. I appreciate it immensely. Click on the beer and iced-tea mug to find out how:

Would you like to be notified via email when WOLF STREET publishes a new article? Sign up here.

  41 comments for “How Bad Will the “Bond Massacre” Get?

  1. DH says:

    Yep, I even saw Louise Yamada speculating today that the bond bull market is over. Interesting times ahead.

  2. Anon says:

    When Las Vegas McCarran Airport needed to borrow money in early 1983, it paid 15% tax free on its 20 year bonds with 15 years of call protection (instead of the traditional 10 years of call protection). A lot of bond investors will be sitting with a lot of unrealized losses soon.

  3. OutLookingIn says:

    The thirty year plus bond bull market is indeed dead.
    Bond holders are dumping their bonds.
    Too many bond sellers and not enough buyers in the market drive interest rates up. It becomes an Ouroboros, feeding upon itself.
    Rates have much room to move up, since they have started near zero.
    Accordingly, bond values have a long way to fall.
    Pension funds are being decimated, as are dollar based loan portfolios that must repay in USD’s with higher rates tacked on.

  4. Justme says:

    Awsome article, love the background material on the relative size of bond-submarkets and the comparison with the size of the stock market.

    Can’t wait for the bond bubble to burst. Not because I want anyone to get hurt, but because correct valuation of market needs to be restored, once and for all. Punish the Wall St speculators, and this time, do NOT give special Fed help to Bansketrs and top 0.1%.

    I think right now the budding bond losses is causing stock market gains, but once it gets serious, bonds, stocks and housing will all go to heck at the same time.

    • Valuationguy says:

      The piece that many are missing here is that BECAUSE the bond market is so big relative to almost every other market (stocks, real estate, commodities, gold, etc.)….any attempts to move capital OUT of the bond markets by investors who recognize the change in the cycle will have the affect of pushing the other market valuation to extreme highs (i.e. even higher than now).

      This is why the fundamentals valuation metrics of the U.S. equity market is so out-of-whack from historical ‘norms’, and most value and growth investors looking at the fundamentals expect a major correction. Instead we are going to see major new highs in the U.S. (40K DJIA) and quite possibly in other global equity markets as investors flee the bond routs.

      Capital ALWAYS chases returns and the coming rout in both foreign currencies (vs. US Dollar) and bonds (due to rising investor demands of yield as financial inflation is rising) …combined with the shadow leverage within the system represented by trillions in credit derivatives….is going to force capital into the US equity markets beyond anything we have seen since the late 1920’s.

      • Wolf Richter says:

        >>> “…move capital OUT of the bond markets…”

        Capital CANNOT be moved out of the bond market (or the stock market, or any market, for that matter): for every seller, there HAS TO BE A BUYER who pays the amount that the seller gets. So for every dollar that leaves the market, a dollar has to enter the market. Only prices change due to the selling pressure.

        Leverage however can disappear without a trace. And suddenly there are a lot of sellers, and not enough buyers, and liquidity issues crop up and prices drop. But still the principle holds: for every seller, there HAS TO BE A BUYER who pays the amount that the seller gets. So not a single dollar will leave the bond market to go somewhere else.

        • Kam says:

          1. On the transaction that is true. It is dollar-for-dollar.
          But if you bought $1 million in bonds last year and have to sell it this year for $970,000 then $30,000 of dollars disappears. Those are your losses.
          Money from nothing can go back to nothing.

          In losses in the bond market you say “And the damage they can do to investors is huge.” What about the losses to savers where by government edict, via it’s nasty child the Fed, “investors” have been piggies at the trough at the expense of current savers and future taxpayers?

        • Wolf Richter says:

          Yes, you lose $30K on that transaction, and it goes up into thin air. But neither the 30K nor the 970K can be sent to other markets to inflate prices there, which was Valuationguy’s point. Capital cannot be “moved” from the bond market to the stock market or to anywhere else. But it can and does evaporate.

          And yes, savers have long been mauled by “financial repression,” as we call it, where the deposit rates they earn, if any, are below the rate of inflation. And that has gotten much worse since the onset of QE. Someone put a figure to it some time ago, how much money savers were screwed out of since 2008, thanks to the Fed. It’s a huge amount, given that there are $11.4 TRILLION on deposit at US commercial banks, but I forgot the number… :-)

          If the difference is 2% per year, on $11.4 trillion, it amounts to over $220 billion a year, over 8 years = $1.8 TRILLION that savers got screwed out of.

        • Alexey says:

          Wait a second, this is not entirely true, and not all markets are different.

          With stocks, yes, you cannot move capital out of stock market by selling your holdings, because someone on the other side is entering the trade.

          However, bonds have a maturity date. By not rolling over the bond the money are repaid to the bond holder without any buyer on the other side, so bond market automatically shrinks.

          Of course, Fed might just counterfeit a bunch of digital dollars and help government to repay the bond principle with these fake digital dollars, but this is entirely another matter

        • Wolf Richter says:

          Yes. Bond redemption, stock buybacks, bond issuance, and share issuance DO MOVE capital from one market to another. For example, Company X issues bonds (add bonds to the market) to buy back its own shares (remove shares from the market): bond buyers give capital to company X which then passes that capital to stock sellers.

          But that’s a different topic than the Valuationguy’s premise.

        • Quinn says:

          That’s one way to look at the market, I suppose, but it leaves out short selling, which allows markets to be dynamic.

          You buy an asset, stock, currency pair, whatever, for $10K in a falling market, hoping for a reversal. It moves against you & you pull the plug at $8K for a $2K loss.

          Another trader shorted the same asset for $10K and buys your position for $8K making $2K profit.

          Both positions are closing positions and out of that particular market, free to move to another, perhaps hotter market.

          Happens all the time. In fact, in any falling market you will find lots of short sellers (unless banned temporarily, which for good reason, rarely happens.)

          All part of capital flows, and money definitely flows out of one market and into another all the time, around the globe.

          Kam: Money doesn’t disappear from the markets. It simply goes into someone else’s pocket.

          To those who would ban short selling:

          Who would buy your position in Lucent for which you paid $70/share in 2000 after it drops like a rock to $50, $40, or $25 when it keeps on falling? (Eventually, it became a penny stock ;^)

          Without short sellers, no one. No long traders, or market makers, are going to bail you out in a falling market before you experience a catastrophic loss unless they can make a profit. Period.

          If markets worked without short sellers, they would have been banned more than a century ago. Hope this helps.

          Good luck to all. Thanks for the blog, Wolf.

  5. michael says:

    looks like a bad time to have a significant amount of debt.

    • NotSoSure says:

      Don’t know about that. Car sales are up big. Or so they say, so a lot of people seems to be comfortable getting car loans. With muppets leading the way, this economy seems to have plenty of bite/byte left :)

      • Wolf Richter says:

        >>> “Car sales are up big.” No they’re not … I’m writing about it right now. They’re up for some companies, but down for others, and guess who they’re down for? The largest ones… stay tuned :-)

        • Karl Szymanski says:

          I suspect that cars shipped from the manufactuer to the dealer are classified as sold. Those cars are still sitting on the dealers lot but are still considered sold by the manufacturer. You can tell by the magnitude of the cash discounts offered by the dealers that the new cars are not being sold.

        • david says:

          Sad almost every piece of govt data and from industry groups….one has to go dig into the data to find the real story.

      • Frederick says:

        Car loans will keep increasing as long as they give longer repayment terms and keep relaxing the requirements And the borrowers won’t even think twice about mailing in the keys and walking away when TSHTF Stay tuned

    • nhz says:

      not in Europe for sure; debtors are laughing all the way to the bank and that won’t change for at least another year (more likely it won’t change until the Euro gets flushed down the toilet) ;-(

  6. Insta says:

    Typo under Type 3 paragraph, 2nd to last sentence, “which old large”, should ‘old’ be owed or had?

    • Wolf Richter says:

      Thanks!! Should be “hold.” That typo wasn’t even funny. Normally, I try to make typos funny – like, infamously, “brick-and-mortal retailers.”

  7. Chicken says:

    Thus, keep an eye on the EWG ETF for your1st indication the bomb is going thermonuclear.

  8. Chicken says:

    Isn’t it true many small US cities are coming up woefully short on their sales tax receipts?

    • Frederick says:

      How could they not with the ACA as well as rents/real estate prices? Americans or 90 percent of us anyway are tapped out

  9. Sean Murphy says:

    Timing is everything. Recently, bonds have been rallying despite healthy corporate issuance already in 2017 ($44 billion I believe). The “but the dip” mentality is alive and well… for now.

    • Wolf Richter says:

      JUNK BONDS have been rallying since February, particularly energy junk bonds. They had a HUGE rally, along with the price of oil. Treasurys, high-grade corporates, munis, etc. have not done well. So the bond market has split in two, with the riskiest bonds having nearly recaptured their prior peak bubble levels, and with low-risk and “risk-free” bonds (Treasurys) selling off sharply.

      • OutLookingIn says:

        There were 150 major global corporations that defaulted in 2016, that is 40% more than the previous year and the highest since the financial crisis.
        Of those 150 corporations, 75% are domiciled in the US, with 50 being in the oil and gas sector. Emerging markets accounted for 28 of the total defaults, with Europe responsible for 12.
        During the forthcoming reset/revaluation, great fortunes will be made by those who place their bets on the correct corporates. Thats if bond holders are respected placeholders at the feasting table.

  10. polecat says:

    with apologies to CCR …..

    ‘Bond Moon A Rise’n’

    There’s a bond moon arise’n
    They’ll be trouble on the way
    U’all in for some nasty weather
    bond losses are gonna come your way

    Don’t look out tomorrow
    you’ll have a heep a sorrow
    There’s a bond moon out tonight

    Interest is inchin ever higher
    Yields are gonna take a fall
    Time to put affairs in order
    Whatever you have, you’re gonna lose it all

    Don’t look out tomorrow
    You’re bound to catch some sorrow
    there’s a bond moon out tonight

  11. Greatful again says:

    Sovereign debt getting more expensive? USD denominated debt causing big problems. These will crush the system. What measures will be taken to halt this? I bet things start to get really crazy as CBs start an attempt to counteract these trends.

  12. Tom kauser says:

    Can’t give your new president money to blow on a wall if your bonds don’t become better value?
    Devalue your currency! Or face much higher borrowing costs and less yearly remittances to the treasury?

    • wkevinw says:

      Currency devaluation seems to be one of the goals for the US. However, they don’t often advertise that. See Plaza Accord.

      • Tom kauser says:

        Demand is already collapsing and we haven’t even got started.
        There was money shuffled it wasn’t created (except around Christmas when bankers get to spend their bonuses)?
        The fed is going to do away with the shadow banking system and enjoy collecting interest on your production long after you are gone!
        Consider that the fed continues to fake sell its 4.4 trillion dollar balance sheet every year and would raise taxes to stop inflation long before entering into a set of interest rate increases which would once and for all destroy its sweet spread deal✌

      • nhz says:

        if that really was the goal they performed poor over the last few years, especially compared to their main competitor/colony Europe.

        The US$ has been one of the strongest currencies for some time now, although in reality of course all are in a race to the bottom.

  13. Cyrus says:

    Anyone has read this about Platinum Partners:

    Makes me wonder how many companies are cooking their books to show far more profit than they really make.

    • Wolf Richter says:

      Probably a lot more than we want to know. Toshiba keeps getting caught. But others do it too and don’t get caught.

      • Cyrus says:

        Yes, I think so too; I think you could say it is a common practice; and I think that if truth was to be known, the stocks market could get a huge trimming just for this one reason, not even considering many other reasons.

  14. Si says:

    Watching the bond market ‘die’ is like watching one of those B movie zombie flicks, where the the ‘undead’ keep coming back to life ….. endlessly.

    I am seriously beginning to wonder whether it can just keep on going forever.

    • Tom kauser says:

      The fed is a fisherman with a giant net and it catches every BOND that swims by!
      The fed crosses out the debt as China sells the bonds back to the fed and the bond goes away?
      When the debt is fullfied the instrument no longer exist and there goes another small bit of collateral to make a new loan contract?

  15. Tom kauser says:

    Once China blows thru its dollars it will start using its gold and since the dollar is strong now it just keeps getting stronger as America controls gold and global interest rate spreads?
    The money power intend to maintain a tight grip on capital formation and strave the world of dollars (more invisible than crashed)?
    The drop in the pound is a signal for liquidation of American assets?

  16. Bill Dumont says:

    Good article, summary and follow ups in the comments Wolf. Spot on!

Comments are closed.