Even though we were expecting the current correction phase, it provides no pleasure to see it arrive. Equity markets suffered broadly during the last month, with US, European, and Swiss equities all decreasing by mid-single digits. However, the most painful market action continued to be in long-dated US Treasuries, where the sell-off has been nothing but brutal.
The 10-year US Treasury yield increased by 50 basis points to 4.6% by the end of September and briefly reached almost 4.9% during the first week of October. With the 5-year US Treasury yield rising to 4.8% and the 30-year US Treasury yield briefly even surpassing the 5% threshold, both have now reached levels not seen in the past 15 years.
Even if bond rates remain high, it’s all good
Bloomberg’s US Treasury Bond Index, which tracks the performance of the US Treasury bond market, is on course to post a third consecutive year of losses, as can be seen in the chart below. According to a Bank of America analysis that looks at 10-year US Treasury bonds in isolation, we are witnessing the worst US Treasury bond bear market in the nearly 250-year history of the US.
As dire as the notion of a secular bear market in bonds may sound, it is crucial to understand that it is vastly different to a secular bear market in equities. Unlike equities, where returns can be negative for many years (as in Japan between the end of 1989 and 2009), a regime of rising interest rates does not necessarily mean that nominal returns are negative for bond investors. As the duration of the portfolio is, by definition, not infinite, capital can be reinvested at increasingly higher rates. So, even if rates remain high, it is all to the good, as coupons can then be reinvested on better terms
We do not mourn the end of the ‘free money’ era
With markets now pricing in the prospect of a ‘higher for longer’ interest rate scenario, the good news is that the financial world is about to conclude a painful transition after a decade of ultraloose monetary policy. As a reminder, after the Global Financial Crisis (GFC), Western central banks began using ultralow or, even worse, negative interest rates and largescale asset purchase programmes to prop up ailing economies and prevent deflation.
Put in historical context, both the US federal funds rate and the 10-year US Treasury yield have reached record low levels. In retrospect, the last decade was an experimental period with respect to monetary policymaking, during which the associated toolkit to steer economic activity was significantly expanded. To be clear, Western central banks’ ability to respond to systemic risk flareups has substantially improved. Their ability to finetune their policy responses is not merely a nice-to-have but an urgent requirement in a global economy that has never been as financialised as today.
Back in March of this year, the US Federal Reserve (Fed) was quick in preventing potential contagion effects as it came up with a new facility to alleviate the regional banking crisis and allow affected entities to receive liquidity by exchanging their US Treasury holdings for cash. However, ultraloose monetary policy, including quantitative easing, has also had undesirable side effects. These include the widening of wealth inequalities in industrialised countries, a defining feature of the neoliberal era that started in the 1980s.
While asset prices – especially of stocks, which are held mostly by those who are already wealthy – enjoyed a strong boost after the GFC, real wages did not keep pace. When money is cheap, or even free, there is also a risk that economic agents will be less disciplined in how they allocate capital, e.g. using it for potentially unproductive purposes such as speculation on financiaassets and funding questionable business models that are only viable under generous liquidity conditions.
In this sense, the return to the cost of money has a desirable cleansing effect. Zombie companies – i.e. companies that are economically unviable and only manage to survive by tapping banks and capital markets – and the associated absence of corporate failures hinder creative destruction and sustained productivity growth. We do not lament the end of the era of free money – far from it, we welcome it as a necessary condition for sustainable growth supported by more efficient allocation of capital going forward.