Fears of bond crash increase as volatility rises
Volatility in bond markets has increased since talk about the Federal Reserve's plans to stop printing money. But analysts say look to Japan, rather than the US
Yields on US Treasury bonds have increased since Federal Reserve Chairman Ben Bernanke warned last month that the central bank could taper its quantitative easing programme.
Patrick Legland, a strategist with Societe Generale, noted that although the recent rise in volatility in bond markets "is clearly a worrying sign," it is still far from the peaks reached after the collapse of Lehman Brothers and at the height of the eurozone debt crisis.
But the sharp rise in the yields of Japanese bonds "reminds us that there is still an anomaly that should be corrected in the next few years," Legland wrote in his twice monthly global research alert.
"The key question remains whether the Bank of Japan will succeed in its policy and be able to maintain rates at low levels medium term," he said. "If not, then the bond bubble could burst rapidly, with dire consequences for financial markets."
Investors should watch Japanese and US bond markets for signs of volatility and for any signs of panic, he recommends.
"For the moment, we do not see indications of an imminent bond crash, but volatility will remain high until we understand better how the Fed exit will be implemented," he said.
The good news is that the rise in bond yields is linked to an improving US economy, which means the current reversal in rates is actually normalization, Legland said.
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Yields on 10-year Treasuries rose slightly last Friday after the non-farm payrolls data, which came in higher than markets had expected, at 175,000 for May.
John Higgins, an economist with Capital Economics, pointed out however that the yields were below their recent highs of around 2.2% and that the US labour market was "hardly firing on all cylinders" as the unemployment rate actually increased slightly to 7.6%.
"The Fed is still likely to tread extremely carefully when considering its future plans for quantitative easing," Higgins said.
He does not believe that the tapering of the Fed's asset buying would lead to a bond crash like the one in 1994.
"After all, the Fed is still likely to continue to keep the federal funds rate at rock-bottom levels until mid-2015 and not sell its holdings of securities for several years after that if at all," Higgins said.
Strategists and economists at Societe Generale maintained their year-end target of 2.75% for US rates and Legland warned that if this scenario comes true, equity markets could be at risk.
"Indeed, five times in the past 30 years in the US, we experienced a rise of rates above 50% from their lows," he wrote.
"On three occasions, this rate shock translated into an equity correction of between 15% and 45%."
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