Bonds revisited - yes, they're turning critical

My series of articles on the bond market a few weeks ago attracted little overt reader interest.  Indeed, I had a few people e-mail with a sort of 'Meh!' response.  They really didn't understand why the bond market was so important, even though I tried to explain it.  I probably didn't do so well enough . . .

Now the bond chickens are coming home to roost.  The inimitable Ambrose Evans-Pritchard explains.

The $9 trillion accumulation of foreign bonds by the rising powers of Asia, Latin America and the emerging world risks going into reverse as one country after another is forced to liquidate holdings to shore up its currency, threatening to inflict a credit shock on the global economy.

India’s rupee and Turkey’s lira both crashed to record lows on Thursday following the US Federal Reserve releasing minutes which signalled a wind-down of quantitative easing as soon as next month.

Dilma Rousseff, Brazil’s president, held an emergency meeting on Thursday with her top economic officials to halt the real’s slide after it hit a five-year low against the dollar. The central bank chief, Alexandre Tombini, cancelled his trip to the Fed’s Jackson Hole conclave in order “to monitor market activity” amid reports Brazil is preparing direct intervention to stem capital flight.

. . .

A string of countries have been burning foreign reserves to defend exchange rates, with holdings down 8pc in Ecuador, 6pc in Kazakhstan and Kuwait, and 5.5pc in Indonesia in July alone. Turkey’s reserves have dropped 15pc this year.

“Emerging markets are in the eye of the storm,” said Stephen Jen at SLJ Macro Partners. “Their currencies are in grave danger. These things always overshoot.”

It was Fed tightening and a rising dollar that set off Latin America’s crisis in the early 1980s and East Asia’s crisis in the mid-1990s. Both episodes were contained, though not easily.

Emerging markets have stronger shock absorbers today and largely borrow in their own currencies, making them less vulnerable to a dollar squeeze. However, they now make up half the world economy and are big enough to set off a crisis in the West.

Fears of Fed tightening have pushed borrowing costs worldwide to levels that could threaten global recovery. Yields on 10-year bonds jumped 47 basis points to 12.29pc in Brazil on Thursday, 33 points to 9.72pc in Turkey, and 12 points to 8.4pc in South Africa.

There had been hopes that the Fed might delay its tapering of bond purchases, chastened by the jump in long-term rates in the US itself. Ten-year US yields – the world’s benchmark price of money – have soared from 1.6pc to 2.9pc since early May.

Hans Redeker from Morgan Stanley said a “negative feedback loop” is taking hold as emerging markets are forced to impose austerity and sell reserves to shore up their currencies, the exact opposite of what happened over the past decade as they built up a vast war chest of US and European bonds.

The effect of the reserve build-up by China and others was to compress global bond yields, leading to property bubbles and equity booms in the West. The reversal of this process could be painful.

There's more at the link.

Remember what I said about interest rates and bond prices?  The higher one goes, the lower the other goes, and vice versa.  It's an inverse relationship.  All those countries who bought bonds at high prices are now holding overpriced assets that they can't sell for what they paid for them.  Many nations that relied on sovereign bonds as part of their foreign reserves are nevertheless having to sell them right now, in order to raise cash to defend their own national currencies.  That means they have no choice but to take that loss - it's become unavoidable.

That's precisely the same risk that the Fed is taking.  It currently owns about $2 trillion (!!!) of US bonds.  If it needs to sell some in a hurry to finance other measures to support the dollar, at the current lower bond prices, it'll take a heavy loss on its investments.  It might even end up technically insolvent.

This is where the interconnectedness and interdependence of world financial markets collides headlong with reality.  The US Federal Reserve cannot take decisions solely in the best interests of the USA, because they will simultaneously affect international markets in a way that may be in the worst interests of at least some other countries.  It's no good to say, "Well, that doesn't matter - they must look to themselves."  They can retaliate in ways that hurt us badly, too - witness the massive sell-off by foreign nations of US bonds that appears to be under way at present.

There are so many factors poised on a knife-edge right now.  Any one of them could trigger a global economic tsunami.  The Syrian civil war . . . Iran's nuclear program, and a possible Israeli counterstrike . . . Japan's conflict with China over the Senkaku Islands . . . Pakistan's internal battle with Islamic fundamentalism . . . the US economy's ongoing woes . . . any or all of these could interact in such a way as to precipitate panic in the financial markets.  When people panic, who knows when, or where, or how it'll end?

I'm worried.  Seriously.

Peter