Taper Car Crash

  • The German 10 year yield makes another new high for the year.
  • The US 10yr is now in the middle of the year’s range, but only 2 weeks ago it was printing a new low for the year at 2.13%.
  • The Japanese 10yr has doubled in the same time period, although that’s only from ~5bps to ~10!

The latter point was enough for the Bank of Japan to pop up this morning and offer to buy unlimited 10yr bonds at 0.11%, and increase their overall JGB purchases from 450bn JPY to 500bn, in an attempt to stem the sell-off.

OMG! Taper Tantrum alert!

Or is it?

The central banks in question have certainly been at great pains to minimise any fear that may come from the anticipated pull back of their epic stimulus programmes:

  • The ECB’s perma-hawk Weidmann today described it as “This is not about a full braking … but taking our foot somewhat off the gas”
  • The BOE’s perma-hawk McCafferty today described it as “a couple of modest rate rises over the next couple of years or so”
  • The BOJ went even further and offered its first fixed-rate purchase operation in 5 months

In a world of ongoing low volatility, this should have been enough to calm things down.
In a world of ongoing low volatility, this should have been the green light for a return to the carry trade.
In a world of ongoing low volatility, the current increase in the geopolitical threat level following North Korea’s missile launch, should have actually seen bond yields go down in a flight to safety.
A bond sell off would usually suggest two things:

  • A “risk on / reflationary” outlook. But we already know, not least from the Fed Minutes this week, that inflation is petering out, and growth numbers in developed nations are stalling (aside from, funnily enough, Japan – where wages just posted their biggest rise in 17 years)
  • A “risk off / get out of everything” panic. Hence the reference to a taper tantrum, which in 2013 knocked risky assets off their perch as the world panicked over whether the global economy really could withstand an exit from unconventionally easy monetary policy

But this isn’t usual.

Remember a few weeks ago we discussed that we are in a period of reassessing what the drivers for financial markets are? We had the cross-cutting currents of Carry, Politics, and the Economy. We concluded in that piece from 6th June:

“What if it’s not? What if, at the exact moment we realise the QE is ending properly, at say, a couple of central bank meetings in the next couple of weeks, we also realise that reflation isn’t quite as robust either? And not just for political reasons?

  • The Carry Trade hasn’t come under any pressure yet as the Central Bank wall of money continues
  • The compression of volatility means that when it does unwind, it will be violent
  • Reflation is under threat, both politically and economically

Firewood? Check.
Tinder? Check.
Matches? Ready.”

Sometimes when the world starts to unwind, it doesn’t come from a specific event. It comes from a dawning realisation about price. At what price are you willing to lend to the German government? At negative rates for 2 years? You’ve been happy to do that for 18 months now:

But as that 2 year yield edged towards -1%, maybe something clicked. Maybe the ECB accidentally revealed the Emperor’s New Clothes when they announced in December that they would allow QE buying to take place at prices through the deposit floor level of -0.40%. This was really a technical change that meant they could continue to buy German bonds. They needed to make this change because otherwise they wouldn’t be able to abide by their capital key proportionality of their QE purchases; in other words, they’d be loaded up with too much Italy and not enough safe Germany. It set off a rational drive down in the German bond yields, because extra demand came into the market. But maybe around -1% all the demand ran out. Fast forward a few months and now the ECB are openly rumoured to be discussing a taper of their programme, even as they’re not explicitly discussing it at meetings. If the mere discussion of a discussion can arrest the bond rally, then what happens when they actually discuss it and then actually do it?

This scenario analysis is now, sensibly, playing out in the market’s mind. Similarly for the UK, which has gone further and had an actual number of dissenting MPC voters for hiking interest rates. Why keep on buying these bonds, particularly at interest rates that ensure a capital loss?

The pennies are starting to drop.

This is much more than a taper tantrum. It’s almost a slow motion taper car crash. A fundamental reassessment of risk-reward will lead to a reassessment of those other drivers we discussed a month ago: why is volatility so low when uncertainty is going up? And why load up on carry when volatility might be about to rise?

We are reaching the realisation that this chart isn’t going to go on forever:

Just as we realise that the risks we face here, now, in 2017, are unquantifiable political ones, and therefore market measures of volatility are woefully mispriced….

Just as we realise that inflation might be petering out….

It’s a hot summer ahead. The tinder is starting to sizzle. A tantrum will be the bare minimum of our reaction.

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