(Bloomberg) — Behind the rally in global debt markets lurks a disaster just waiting to happen. At least, that’s what some long-time market watchers are warning.
While dovish comments by the Federal Reserve and other central banks have prompted investors to pile back into bonds, two troubling developments could make buyers uniquely vulnerable to deep and painful losses, they say. One is the sheer amount of ultra-low yielding debt, which means investors have almost no buffer in the event prices drop. That’s compounded by the worry liquidity will suddenly evaporate in a selloff and leave holders stuck with losses on positions they can’t get out of quickly.
Granted, nobody is actually predicting when things will turn ugly in the bond market, and history hasn’t been particularly kind to the doomsayers. Still, the risk is real, they say, and caution is more than justified. By one measure, the amount of investment-grade bonds has doubled to $52 trillion since the financial crisis. And yields have, on average, fallen to roughly 1.8 percent, less than half the level in 2007. If they were to rise by a mere half-percentage point, investors could be looking at almost $2 trillion in losses.
“This is an element of hidden leverage that is not appreciated,” says Jeffrey Snider, global head of research at Alhambra Investments. “We are eventually going to have a shock.”
The current situation is a legacy of the easy-money polices enacted by central banks following the financial crisis. With interest rates at or near zero, governments and corporations went on a historic borrowing binge — and investors gorged on debt that yielded little in return. What’s more, rules to strengthen financial firms and curb their risk-taking meant the big banks now played a much smaller role as intermediaries, transferring more of the risk of getting in and out of trades onto investors.
Using the US Treasury 10-year (yellow) and 3-year Treasury (green) yields, here is a chart of global Treasury modified duration (white).
Yes, the pounding of global interest rates downwards thanks to Central Bank “easing” has created a potential duration. wipeout.
And the short-term Central Bank rate hammer is helping to keep global rate depressed, leading to higher duration risk.
Yes, the Central Banks DID do that!