I’ve been waiting seemingly forever for the financial markets to show some acknowledgement that central bank stimulus policies can’t go on until the sun turns into a dark cinder. For how long have I been waiting? More than a year certainly. But each time I think that the market is ready to at least think critically about the belief in a guarantee that there will always be another round of stimulus from the European Central Bank, the Bank of Japan, and the People’s Bank of China, I’ve turned out to be wrong. Nothing–not negative interest rates, not the exhaustion of the supply of bonds for purchase–has been enough to set off significant doubts in this guarantee. Not even the Federal Reserve’s initial interest rate increase in December 2015 was enough to disturb the narrative for very long.
And now? Maybe. At least for a day. And I think for longer.
Yesterday the European Central Bank not only didn’t add expected stimulus to European financial markets, but bank president Mario Draghi didn’t even promise future stimulus.
Today financial markets–led by bond markets with equity markets joining in–are anxiously wondering if they need to rethink the assumption of an endless supply of stimulus. Besides yesterday’s non-move and rhetorical silence from the European Central Bank, today the market is reacting to remarks from Federal Reserve Bank of Boston President Eric Rosengren that waiting too long to raise interest rates would threaten the U.S economy. And to a forecast that the Bank of Japan is looking at a policy that would let long-term interest rates rise in that market.
The result has been a drop in U.S. stocks of 2.45% on the Standard & Poor’s 500 at the close–that’s the first move of more 1% in either direction since July. The yield on the 10-year Treasury jumped to its highest level (as prices retreated) since June with the yield ending the day at 1.67%. Yields on the German 10-year bund climbed to 0% for the first time since July. Emerging market assets, which had rallied as yields in developed markets fell and investors and traders looked for higher returns, took it on the chin. The iShares MSCI Emerging Markets ETF (EEM) was down 3.37% at the close.
The odds for an interest rate increase from the Federal Reserve sometime in 2016 climbed above 60%.
My belief is that this turn will last for more than a day. How long it will run will depend on what the Bank of Japan (meeting September 20 and 21) and the Federal Reserve (its rate-setting Open Market committee meets on September 21) say (since they’re not likely to do much of anything) at their respective meetings the week after next. That will keep the retreat going in global bond markets or–yet once again–reverse it.
The indexes and bonds that sold down today finished the session without an end of the day recovery. That tends to mean the trend will continue into coming sessions. The market for Japanese government bonds, which has been leading the way in recent moves to the downside, is in the midst of its worst sell off in 13 years. And Bank of Japan Governor Haruhiko Kuroda has suggested recently that he would like to see a steeper yield curve and that low long-term interest rates are damaging the Japanese economy. A steeper yield curve in Japan would likely translate into a fall in prices of longer-dated (10- and 30-year) bonds in global markets
We’ve had a big move in yields on the U.S. 10-year Treasury already, though, and at a yield of 1.67% it’s not clear to me how much higher 10-year yields will move in the short term. Certainly 1.75% is possible. The likely pressure on bond prices remains to the down side but I wouldn’t expect a rout in U.S. bond prices and a spike in yields. Remember the Fed is looking at raising short-term rates–the only interest rates that it directly controls–to just 0.75% with the next move higher.
I will spend the weekend trying to figure out what to do with the long-dated Treasury bond ETF in my Jubak’s Picks portfolio. More on that specific question on Monday.