2012-12-28
Over the past months we have heard many warnings about the bond market — most say it is a bubble waiting to pop. But nothing happens. The world is still in love with bonds.
We have begun to view the warnings like those of the boy who cried wolf once too often. Investors, like the villagers of Aesop’s fable, have become inured to the cries. The inflation-linked bond markets seem complacent, and recent government inflation numbers have been tame.
It is often when investors are overweight bonds and think that the climate is perfect for bonds to rally to new record high prices that the bottom of the bond market falls out. Overbought markets can continue for years, but bond supremacy could be challenged in 2013 as growth and inflation reassert themselves.
Some of the conditions that will precipitate this fall are already in place. I think some of the ingredients for the possible disorderly repricing of the bond market are also already in place.
Economic growth is the chief catalyst
It seems to me that continued US, European and emerging market economic growth will be the chief catalyst.
And the elements are in place for this growth to take place. In the United States, rising home prices and lower commercial vacancy rates are increasing demand for new construction projects, which means jobs. Increased employment will boost spending.
Easier monetary conditions abroad and favorable currency trends are creating the conditions for better growth in the world in 2013.
Growth breeds inflation
In line with faster global growth, we are bound to experience faster inflation — the great leveler of the bond market. Bonds will obviously get hit if inflation accelerates. This pattern has repeated itself throughout history. That acceleration would prompt an increase in rates and cause significant principal destruction for investors. In theory, Treasury yields should reflect several things: the real growth rate, current and future inflation risk, and a slight premium for liquidity. None of that is apparent today.
Inflation isn’t an immediate threat, however. It needs three conditions to take hold: loose monetary policy, the removal of excess capacity in US factories and the absorption of slack in the labor market. Only the first of these conditions is in place.
However, how long would it take for us to see full capacity utilization and peak employment?
Capacity utilization in the United States is around 78%, but at current economic expansion rates of growth, this number will hit 80% by the fourth quarter of 2013. Economic historians know that 80% usage rates lead to shortages and bottlenecks and that the marginal pricing of goods, in turn, rises.
As for employment, the third and most important element necessary for inflation, the excess supply of skilled labor in the jobs market is slowly dwindling. At current growth rates in payrolls, we could fall below the all-important 7% unemployment rate (slack) by year end 2013. This is critical, because at a 7% unemployment rate, the marginal cost of labor tends to rise, and tends to rise faster than the economic pace of growth. Since wages directly or indirectly make up 50% of the Consumer Price Index, the most widely followed inflation indicator, this will begin to affect the reported numbers in the CPI, driving reported inflation up.
So what exactly will happen to the bond market when growth and inflation pick up?
Seeking yield
More confident investors will look for higher returns, which will most likely be found in riskier asset classes. Stocks, for instance, often provide better historical returns in the initial phases of rising inflation. Commodities also could attract risk seeking funds.
Right now, markets are not pricing in much inflation risk at all, but that complacency could evaporate in minutes. Historically, the biggest sell-offs in the bond world have been connected with bursts of inflation. If the bond markets begin to reprice, the risk is that the large owners of US Treasuries, such as the People’s Bank of China, the US Federal Reserve, the Bank of Japan, pension funds and active managers may decide they all want out at the same time.
So as we enter this new year, I suggest we all proceed with caution and be vigilant for the first sign of inflation.
No forecasts can be guaranteed.
The views expressed are those of James Swanson and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation or solicitation or as investment advice from the Advisor.
24134.14
How close are we to a bond cliff?
Over the past months we have heard many warnings about the bond market — most say it is a bubble waiting to pop. But nothing happens. The world is still in love with bonds.
We have begun to view the warnings like those of the boy who cried wolf once too often. Investors, like the villagers of Aesop’s fable, have become inured to the cries. The inflation-linked bond markets seem complacent, and recent government inflation numbers have been tame.
It is often when investors are overweight bonds and think that the climate is perfect for bonds to rally to new record high prices that the bottom of the bond market falls out. Overbought markets can continue for years, but bond supremacy could be challenged in 2013 as growth and inflation reassert themselves.
Some of the conditions that will precipitate this fall are already in place. I think some of the ingredients for the possible disorderly repricing of the bond market are also already in place.
Economic growth is the chief catalyst
It seems to me that continued US, European and emerging market economic growth will be the chief catalyst.
And the elements are in place for this growth to take place. In the United States, rising home prices and lower commercial vacancy rates are increasing demand for new construction projects, which means jobs. Increased employment will boost spending.
Easier monetary conditions abroad and favorable currency trends are creating the conditions for better growth in the world in 2013.
Growth breeds inflation
In line with faster global growth, we are bound to experience faster inflation — the great leveler of the bond market. Bonds will obviously get hit if inflation accelerates. This pattern has repeated itself throughout history. That acceleration would prompt an increase in rates and cause significant principal destruction for investors. In theory, Treasury yields should reflect several things: the real growth rate, current and future inflation risk, and a slight premium for liquidity. None of that is apparent today.
Inflation isn’t an immediate threat, however. It needs three conditions to take hold: loose monetary policy, the removal of excess capacity in US factories and the absorption of slack in the labor market. Only the first of these conditions is in place.
However, how long would it take for us to see full capacity utilization and peak employment?
Capacity utilization in the United States is around 78%, but at current economic expansion rates of growth, this number will hit 80% by the fourth quarter of 2013. Economic historians know that 80% usage rates lead to shortages and bottlenecks and that the marginal pricing of goods, in turn, rises.
As for employment, the third and most important element necessary for inflation, the excess supply of skilled labor in the jobs market is slowly dwindling. At current growth rates in payrolls, we could fall below the all-important 7% unemployment rate (slack) by year end 2013. This is critical, because at a 7% unemployment rate, the marginal cost of labor tends to rise, and tends to rise faster than the economic pace of growth. Since wages directly or indirectly make up 50% of the Consumer Price Index, the most widely followed inflation indicator, this will begin to affect the reported numbers in the CPI, driving reported inflation up.
So what exactly will happen to the bond market when growth and inflation pick up?
Seeking yield
More confident investors will look for higher returns, which will most likely be found in riskier asset classes. Stocks, for instance, often provide better historical returns in the initial phases of rising inflation. Commodities also could attract risk seeking funds.
Right now, markets are not pricing in much inflation risk at all, but that complacency could evaporate in minutes. Historically, the biggest sell-offs in the bond world have been connected with bursts of inflation. If the bond markets begin to reprice, the risk is that the large owners of US Treasuries, such as the People’s Bank of China, the US Federal Reserve, the Bank of Japan, pension funds and active managers may decide they all want out at the same time.
So as we enter this new year, I suggest we all proceed with caution and be vigilant for the first sign of inflation.
No forecasts can be guaranteed.
The views expressed are those of James Swanson and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation or solicitation or as investment advice from the Advisor.
24134.14
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