While all eyes have been on the big gyrations in the share market, most of that price action has stemmed from large moves in the bond market which is going to be central to what happens next.
In simple terms, there is a battle going on in the bond market between central bankers – including our Reserve Bank – and bond buyers, who are refusing to buy longer term bonds unless they have a higher interest rate.
Bond buyers winning tug of war with central banks
At this stage, the bond buyers are winning, which is shown by Australian 10-year bond rates which have jumped from 0.7% in October last year to around 1.6% now.
In the US bond market, the rate on 10-year Treasury bonds has gone up to 1.5% from around 1% at the start of this year.
While the central banks have largely been more successful at holding down rates on shorter term bonds by buying them up, 10-year bonds have been on the rise as buyers demand higher yields to make up for the uncertainty of inflation and also higher interest rates as the world economy roars back from the COVID-19 pandemic.
Just last Friday the RBA offered to buy $3 billion in three-year bonds maturing in April 2023 to April 2024.
Warren Buffett weighs in
That came on top of a further offer to buy $3 billion of three-year bonds a day earlier but the moves to steady the bond market were not entirely successful.
Even the world’s most successful investor, Warren Buffett, wrote about the issue in his letter to Berkshire Hathaway shareholders, saying that fixed-income investors “face a bleak future.”
“Bonds are not the place to be these days,” Mr Buffett said in the letter, also pointing out that the income yield on US 10-year bonds had fallen 94% since September 1981 and that in some countries such as Germany and Japan, yields had turned negative.
That is where the real tug of war comes into it – will the bond buyers succeed in demanding higher yields or will the concerted actions of the central banks force longer term interest rates back down again?
Bond market holds key to share price growth
It is a vital question for the share market with rising rates and inflation generally seen as bad for shares and lower rates as better.
Higher rates feed directly into the valuation models used by most brokers, which means that share valuations will fall as a direct result of a higher 10-year bond rate.
Locally, RBA Governor Dr Philip Lowe has gone right out on a limb by saying that official rates in Australia will not rise until at least 2024 but that position will come under intense strain if the 10-year bond yield keeps blowing out.
At the end of the day, all countries that run Budget deficits need to sell bonds to keep the wheels turning and they can’t sell them all to central banks, so the bond market is still in control of bond yields to some extent – particularly at the longer end.
Some bond buyers are sitting on big capital losses
It is worth remembering that some of those market participants have just suffered massive capital losses, given they have been buying 10-year bonds with yields under 1% and the market has moved significantly higher.
With US President Joe Biden successfully getting a US$1.9 trillion (A$2.45 trillion) COVID-19 relief plan through the House of Representatives, chances are the US is going to need every bond buyer it can find to continue to finance its Budget, so it could well end up being a price taker than a price maker on bonds with maturities of 10 years or more.
It may be that inflation doesn’t eventuate as fast as hoped and yields soften a little, but the opposite could also be true.
Why not take advantage of low rate, fixed loans?
When you filter this bond market tug of war further down through the economy, it raises some interesting conundrums.
Such as, why wouldn’t you fix part of your home loan at current low rates to lock in what could well be the low point of the cycle?
Or, why wouldn’t you base your share market buying activity more on proven profitable sectors of the market that should recover as we work through the pandemic rather than add to the already sky-high prices of some technology darlings that are defined as “growth’’ stocks?
And perhaps most importantly, how comfortable am I in paying back my current loans if interest rates on them were to rise?
Time to model effect of higher rates on borrowings
Once interest rates start to rise, they normally add on around 10 rises of about 0.25% which would see housing rates of around 5% or more. This may be a very sobering thought given the stratospheric debt levels many people are committed to.
It may be that Dr Lowe is right and that rates don’t go up at all until 2024 or later, but it also may be true that we are seeing the first stage of a bond market build-up that will see rate rises flow through earlier than that.
So, the choice is to relax and believe the central banks or look at the market moves and be a bit more cautious and model what would happen to you if there was an earlier start to interest rate rises.
Whatever ends up happening, that latter approach seems more prudent.