Not to be alarmist, but something truly bizarre happened in the financial markets this week: For a brief period, investors were being paid to buy debt issued by Germany, the famously prudent government borrower. What witchcraft is this?
This is some of the safest debt on the planet — so attractive to global investors that demand had pushed benchmark 10-year yields into negative territory since 2019. That meant investors effectively had to pay to hold German government bonds.
The adage went: Never ever sell the Bund. But it seems some fund managers did exactly that this week, cranking up yields. Crucially, the apex of those yields was above zero. Truly, these are the end times.
I jest of course. Yields on those Bunds rose only to a mighty . . . (drumroll please . . .) 0.02 per cent. The excitement was shortlived; the allure of the deep freeze was just too much for the market in the end, so yields popped back below zero shortly afterwards.
Nonetheless, this was a big moment, and not only because it offers a taste of the beginning of the end of Europe’s long experiment with negative yields. In markets, people often talk in wishy-washy terms of important benchmarks breaching “psychologically significant” levels. In reality, these are generally just round numbers. But numbers do not come much rounder than zero, and 10-year Bund yields have not been positive for a very long time. The mood across global markets has shifted, fast.
Germany itself, or the eurozone, is not really the focus here. Instead, as ever, the incident stems back to US interest rate policy and its all-encompassing hold over global asset prices.
Towards the end of last year, investors started to take seriously the prospect that the Federal Reserve would start bumping up interest rates. This year opened with growing certainty that the Fed would raise rates three times this year. Now, markets are tilting heavily towards the view that it could be four. The unlikely prospect of a half-percentage-point rise as soon as March has even gained some traction.
JPMorgan chief executive Jamie Dimon has even posited that there could be six or seven rate rises this year. I’d be curious to know how this went down in the bank’s specialist economics team, which is expecting four.
Dimon’s is neither a mainstream nor a disinterested view; he is clearly a heavy-hitter but not a rates strategist, and banks generally do well in environments of rising interest rates. Still, the fact that serious people are saying this kind of stuff out loud tells you precisely why US yields have swept higher, taken Bunds along for the ride and bitten a chunk out of speculative assets. CNBC’s red “markets sell-off” chyrons have been working hard.
The speed of the change in expectations is itself a reason for caution. “One of the biggest mistakes people make is thinking that financial markets are rational,” says Martin Horne, head of global public fixed income at Barings. “The market reaches for answers but it is frequently wrong.”
It is nonetheless worth trying to sketch out in more detail how the impending cycle of rate rises might pan out across markets. The bear case, outlined engagingly this week by GMO’s Jeremy Grantham, is that the Fed has facilitated a “superbubble” across markets, creating a “vampire” that has proven resistant to death. Now “it seems as if the confidence termites attack the most speculative and vulnerable first and work their way up . . . Let the wild rumpus begin”. The issue there, as Grantham accepts, is that he said roughly this in January 2021 too. Since then, the S&P 500 has risen 17 per cent.
Goldman Sachs suggests the new era need not necessarily be too painful. “The nine Fed hiking cycles since the 1970s were mostly [positive for riskier assets],” it said in a mid-January note. “We think equity investors should worry more about when the Fed stops hiking or even cuts rates, as that indicates growing risks to the cycle.”
Short-term volatility is unavoidable, of course. The Nasdaq Composite’s drop into correction territory this week after a 10 per cent decline from recent peaks is evidence enough of that. But as Goldman’s analysts suggest, that is mostly because of the rapid speed with which investors have turned hawkish.
Mark Sobel, US chair of think-tank OMFIF, says equity markets are only slowly getting the message that the Fed’s view has changed sharply. He notes that the S&P 500 index of US stocks is still higher now than it was in September. “To be sure, the monetary policy outlook has triggered some down days for the market, especially for the tech sector. Yet, equities remain richly valued.”
He added: “A communications jolt may be in order . . . A measured jolt could help better align financial markets and conditions with the Fed’s rhetoric and outlook, without triggering undue volatility. While this is much easier said than done, the talented penmanship and wordsmithing of the excellent Fed staff scribes should easily be able to navigate such shoals.”
Keep an eye on that “psychologically significant” German debt benchmark to see how well they do.