Over the past six months, the global bond market has crashed in spectacular fashion, wiping out trillions of dollars in value from supposedly ‘safe’ investments.
We predicted this would happen in The Daily Reckoning Australia Weekend on 18 September 2021 and explained why it’d happen too. Today, it’s time to review, determine what happens next, and explain why the crash matters.
Back then, we wrote:
‘Bonds are now a lose-lose-lose proposition. And yet, almost all investors hold them, directly or indirectly. They’re the building block of portfolios and a key part of asset allocation.
‘Since the ‘80s, the bull market in bonds has been downright awesome. As interest rates fell, not only did investors benefit from high yields and falling inflation, but they also generated good capital gains.
‘This triple boost to bond market returns is what has made us so complacent about holding them, and what made bonds so popular too. But it is over. All three tailwinds are turning into headwinds.
‘In the future, bond yields will be below inflation, defaults will destroy invested capital, and bond prices will plunge, causing capital losses for anyone who joins the panic and sells out.
‘This means that, at some point, we’re going to see a panic of some sort in the bond market. And when bond markets panic, it’s far more destructive than a stock market rout.’
This is true for a long list of reasons, which you’re about to experience.
But first, let’s dig into the crash that has happened since our warning. In fact, by some measures, that’s the very month when bond values topped out. But what happened next?
First, there are capital losses from bond prices falling. Jim Bianco of Bianco Research puts this value at US$5 trillion in losses. German finance journalist Holger Zschaepitz calculates US$6.4 trillion. It depends on which bonds you include and what time frame.
Indeed, some bonds are through the floor. An ETF of US 20-year treasuries was down about 30% at one point!
Now, if global stocks crashed that much, it’d be headline news. But there hasn’t been any mention of the bond crash.
This is especially ironic given government bonds aren’t supposed to crash at all. They’re a promise to repay a fixed amount of money at a fixed time in the future, with no default risk, because the government is your creditor, and it can always print the money.
So how can their value fall?
It was a game of Old Maid, the Greater Fool Theory, or whatever you want to call it. Bond prices had been rising for 40 years, delivering good gains for investors. Betting against them was a mug’s game for much of that time, even if it made sense to do so.
Like all good bubbles, it’s incredibly difficult to predict how far they’ll run — how irrational they’ll get — before they pop.
But the key point is that when they do pop, the same momentum that gave them irrational upside turns around and begins to add to the downside crash.
Here’s how I explained that in September 2021:
‘An adjustment to more reasonable bond yields implies falling bond prices and thereby capital losses for bond holders. That’s because bond prices have to fall for their yields to rise, just as share prices have to fall for dividend yields to rise.
‘But this capital loss reverses the traders’ incentive for holding bonds in the short term as their prices are bid up. And that could mean traders make a dramatic attempt to get out of a burning theatre at the slightest hint of smoke.
‘Bond prices could overcorrect to the downside as nobody wants to be left holding a bond that may default, and which pays a yield that doesn’t even compensate for inflation, and which has a falling price too.
‘If the main reason to invest in something is that “it is going up” then when it stops going up…’
And so, the crash has taken on its own momentum. Bonds are now so oversold in the short term that even those who believe bonds are still overvalued are considering buying them to trade the short-term bounce back.
But longer term, things still look dire for bonds. The crash may have only just begun.
It’s important to note that so far, the crash has barely been a blip on the 40-year trend of higher bond prices. And the crash so far has barely delivered positive real (inflation-adjusted) yields in bonds.
So if inflation remains high and yields continue their trend to more normal levels post the bubble’s popping, this is only the beginning of the misery for bonds.
What are the implications of all this? Apart from the whopping losses for investors, I mean.
Well, bonds are a building block of the financial system. They’re the foundation, even.
Banks and insurance companies own bonds as a low-risk foundation of their balance sheet. When bond prices crash, this undermines those institutions.
Worse, the government’s interest bill is determined by bond yields. And the government’s borrowing costs are surging as bonds crumble. This is with debt at record levels in many cases.
The impact on government interest expense is only slowly felt over time because bonds are a bit like a fixed-rate mortgage, and so higher rates only matter when the government tries to borrow new money.
But the government has so much debt that it constantly borrows more to refinance old borrowings that come due, so the changes do shift the cost fairly quickly.
The same goes for companies. They’re facing higher borrowing costs too.
And then there’s mortgages, where the pain is felt much faster. US average annual mortgage payments have surged 35% past their previous high, set in 2006, because of the crash in bond markets.
Loan demand is plunging as a result. CNBC reported earlier this month that ‘Surging interest rates push mortgage demand down more than 40% from a year ago’.
I wonder what might happen to house prices…?
Heck, the losses on bonds are so bad that even central banks will need bailing out! They’ve been buying up bonds like there’s no inflation tomorrow for years now.
Over in the UK, the Bank of England has an indemnity on the Treasury of the losses on such Quantitative Easing. This could mean the Treasury has to send payments of 400 million pounds next year according to the Office of Budget Responsibility and 2.6 billion pounds the year after that!
To be clear, this is the broke bailing out the money printers…
Ironically enough, the expectation of tighter monetary policy from the money printers has triggered the sell-off in bonds. We explained that in September 2021 too:
‘So, what happens when governments and central banks withdraw their support for companies post-COVID and the defaults they have thus far prevented start to play out?
‘Then the yield on bonds won’t matter because of the risk you’ll lose your initial investment in a default.
‘Thus, even if inflation falls, the bond market is a time bomb.’
Over in Japan, they’re so worried about the bond crash that the central banks have promised to prop up Japanese government bonds by buying an infinite amount to keep the price high.
Unfortunately, this has had the side effect of causing the yen to crash instead. It’s down to a 20-year low after falling for the longest losing streak in 50 years.
The point is bond market chaos might not be showing up in your local newspaper. But its consequences are starting to have an impact on you.
Where to next?
Well, the bond markets are oversold in the short term. And a recession is on the horizon, which would be good for bonds too.
But one of the lessons of financial history is that you can’t reinflate a bubble that has popped. And the bond market’s bubble has popped.
Until next time,
Editor, The Daily Reckoning Australia Weekend