By Martin Tillier
When you work in financial markets, there are certain things that are embedded in your thought process over time. When you leave and return to the real world, it comes as a shock that what is obvious to you is seen differently by retail investors.There is a perception gap between Wall Street and Main Street if you will. I notice this most in the view of the relative importance of different markets.
To the average investor, stocks lead everything. They are most interested in the stock market and that is what is reported everywhere. I have yet to see a broadcast network news show end with an update on the 10 Year yield, but “The Dow Jones finished the day...” is a quite frequent refrain.
To those who are paid to trade, however, stocks are lower in the financial food chain. Forex leads, with bonds in second and stocks third in importance.
When you think about the way money moves, it isn’t that surprising. When cash moves from country to country it seeks a home. Government bonds (US Treasuries, JGBs, Bunds, Gilts, etc.) are the initial parking place for that money, and from there it moves to stocks.
The forex part of the equation is of interest to me for obvious reasons, but for most people who invest with a domestic bias, it is the relationship between stocks and bonds that counts. That relationship was, in the past, always said to be an inverse one. If stocks went up, bonds went down. It was simple.
That relationship was fractured following the recession. As central banks began bond buying programs, known as Quantitative Easing, stocks and bonds began moving in unison. The purchases put upward pressure on bonds, and the deployment of the proceeds pushed stocks the same way. To old market guys like me it represented the end of the world; order had been destroyed and chaos reigned!
In recent weeks, however, some order has been restored. Now that we are once again living in a sane world, we can revert to looking at the bond market for clues to the stock market here in the US.
For a couple of years now, conventional wisdom has been that the bond market is about to collapse. Of course, it hasn’t happened, but the case is still convincing. Interest rates have been on a steady downward slope (and therefore bond prices on an upward one) for 30 years (see chart below). It has to come to an end.
With the end of American QE in sight, talk has again begun of a coming collapse in bonds. Once again, however, I believe it is exaggerated and premature.
First, the obvious...
Amid all of the talk, it is easy to lose sight of the fact that QE is still continuing at the previous rate here in the US. The Federal Reserve is still creating $85 Billion each month out of thin air and using the money to buy bonds. As long as that continues, a collapse is virtually impossible.
Secondly, in order for a bubble to burst, you have to have a bubble in the first place. Those who point to the chart above to say that there is one are missing the point. The reason for the gradual drop in bond yields is that, economically, the world has become a safer place.
Central banks have learned how to avoid raging inflation and the subsequent high interest rates. Even the flood of retail money into bonds following the recession doesn’t constitute a bubble. It was merely a logical response to worrying times. In the last few months, we have seen money moving out of bonds, but the exit has been quite orderly.
As QE draws to a close, the rate of exit from bonds is likely to increase, but at $45 Trillion, the global bond market can handle it.
To me, the bond market resembles a balloon more than a bubble. It has been gradually inflated over time, and like the party balloon left tied to a chair long after the guests have left, will likely deflate slowly.
I believe talk of a bursting bubble in bonds is just that... talk. Rates will likely normalize over the next couple of years, but the overall effects on other markets are likely to be muted.
As usual, the sensationalists and merchants of doom and gloom should be ignored. In the words of the great Bobby McFerrin, don’t worry, be happy!
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Martin Tillier has a wealth of experience in Foreign Exchange. He started working for a major interbank Forex broker in London in the 1980s, rapidly acquiring more responsibility and the authority to run larger positions. After several years, he was asked to go to Tokyo to develop the cable (USD/GBP) desk there. He returned to London at a time of turmoil in European currency markets and helped build the company's Sterling Mark (GBP/DEM) desk into the world's most profitable, in the years leading up to the Euro. Highlights included a 36 hour unbroken stint at the desk during black Wednesday, when the Pound was forced out of the European Monetary System. Because of his success in London and his ability to teach new recruits the complex world of Forex trading, Martin was asked to establish Spot FX desks in new markets for the company, first in Moscow, Russia, then in Warsaw, Poland. He left the market in 2002 and moved to the US, following the loss of a family member in the tragic events of September 11th 2001. He spent some time out of the markets, starting and running a successful wine store, but the lure of the financial world was still strong, leading to him selling that business and accepting a position as a financial advisor with a major firm. The frustration he felt while there is what led him to his current position as a writer and educator on markets, particularly Foreign Exchange. The markets were more accessible than ever, but it seemed Wall Street was still doing fine. It was obvious that the retail trader and investor were at a disadvantage, and education could close that gap. Martin now writes regularly for Nasdaq.com and other financial sites, trades Forex and other markets successfully and, in his spare time, plays golf badly. |
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