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Published: Mon, February 12, 2018
Global Media | By Abel Hampton

Ignore the stock market rollercoaster, the sell-off in bonds is what matters

Ignore the stock market rollercoaster, the sell-off in bonds is what matters

Analysts, who have said for months that the financial markets were due a correction after a long period of rising prices, urged calm.

At prevailing bond yield of 7.56 per cent, one would then require 13.56 per cent (adding 6 per cent risk premium) on equity to make a switch from bonds. And the more bond yields rise, the more will be this opportunity cost. US government bonds, meanwhile, are considered virtually free of risk of default.

"What's the right multiple you're willing to pay?..." He said recently when Treasury yields were in the low 2 percent range, price-to-earnings multiples were able to get to about 18 percent. The earnings yield for stocks, even after their wonderful run-up in the past year and a half - and factoring in Friday's drop - is a relatively high 5.6 percent. The BEER ratio (bond yield/equity yield) now stands at 1.85, suggesting that equities are overvalued.

The selloff in world stock indexes deepened on Thursday, with the fall in USA stocks confirming a correction for the market, in another volatile session stirred by concern over rising bond yields.

What is making bond yields rise? One is the substitution factor - investors might switch their money to bonds if the yield climbs high enough. A higher fiscal deficit leads to a spike in government borrowings, especially when government's revenue generation has been sluggish. The latest tantrum came on concerns about more deficit spending in Washington, after the Senate struck a budget deal that raises the spending cap by $300 billion, more than the market expected.

Long-term investors such as pension funds and insurance companies are also giddy at the prospect of a selloff in bonds that would push rates back up to the levels of yesteryear.

Furthermore, the Federal Reserve - in Janet Yellen's final meeting as chair - was more hawkish than in previous meetings, increasing the likelihood of an interest rate rise in March. This is not a bad thing, it's a normal and common readjustment in the market. But it certainly prompts central banks to take monetary action, which reduces liquidity in the system.

Euro zone yields were also higher while a hawkish comment from the Bank of England regarding interest rates drove down United Kingdom stocks about 1 percent and boosted yields on United Kingdom government bonds to the highest since 2015.

"We don't have a lot of panic". European Central Bank too picked up even junk bonds from various countries.

Jim O'Neill, Former Commerce Secretary in the United Kingdom government, on Monday said the USA is growing and the central bank may need to tighten monetary policy faster than the market has perceived.

Two weeks later, another billionaire, Ray Dalio of hedge fund firm Bridgewater Associates, piled on with a forecast of the worst bear market since the early 1980s. We haven't had inflation, and now we have it and everyone freaks out.

The question for investors is how high do yields go.

There are speculations that the US Fed may turn hawkish, if inflation hits the target of 2 per cent growth. The spread between stock and bond yields is double that now.

Market expectations for Fed interest rate hikes also faded. It is preparing markets for two-to-three rate hikes, so that it can actually deliver one or two. At the same time as ten-year break-even rates have risen, so have oil prices.

Since the start of the year, prices for developed-market sovereign bonds have been in decline, sending yields sharply higher.

The Dow Jones Industrial Average .DJI fell 1,175.21 points, or 4.6 percent, to 24,345.75, the S&P 500 .SPX lost 113.19 points, or 4.10 percent, to 2,648.94 and the Nasdaq Composite .IXIC dropped 273.42 points, or 3.78 percent, to 6,967.53.

Policy accommodation has helped the cost of servicing debt for companies in the S&P 500 fall to an all-time low of 3.5 per cent of sales over the past 12 months, according to data compiled by Bloomberg.

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