How Bad Will the “Bond Massacre” Get?

by Wolf Richter, Wolf Street:

Worse “than the 1994 ‘Bond Massacre,’” with “sustained double-digit losses on bonds, subpar growth in developed markets, and balance sheet risks for banking systems….”

The backdrop: after 36 years of bond bull market, the amount of US bonds has ballooned to $47 trillion, up 24% from just ten years ago:

US Treasurys ($19.8 trillion),
Municipal bonds ($3.8 trillion)
Mortgage related bonds ($8.9 trillion)
Corporate bonds ($8.6 trillion)
Federal Agency bonds ($2 trillion)
Money Markets ($2.6 trillion)
Asset backed Securities ($1.3 trillion)

Bonds dwarfs the US stock market capitalization ($27 trillion). Bonds are a global phenomenon with even bigger bubbles elsewhere, particularly in NIRP countries, such as those in Europe, and in Japan. That’s why bonds matter. They’re enormous. And the damage they can do to investors is huge.

So how bad might the next bond bear market get? Paul Schmelzing, a visiting scholar at the Bank of England and an academic at Harvard where he concentrates on 20th century financial history, published an unpleasant scenario on the Bank of England’s blog. He doesn’t mince words:

[A]s rates reached their lowest level ever in 2016, investors rather worried about the “biggest bond market bubble in history” coming to a violent end. The sharp sell-off in global bonds following the US election seems to confirm their fears. Looking back over eight centuries of data, I find that the 2016 bull market was indeed one of the largest ever recorded. History suggests this reversal will be driven by inflation fundamentals, and leave investors worse off than the 1994 “bond massacre.”

To arrive at his conclusion, he classifies bond bear markets into three types:

The inflation reversal of 1967-1971
The sharp reversal or “Bond Massacre” of 1994
The steepening yield curve or “value-at-risk shock” in Japan in 2003.

He explains that “historically, inflation acceleration has been a solid predictor of sharp bond selloffs.” But other “prominent episodes appear less correlated with fundamentals, and can inflict similar levels of losses.”

Type 1: The inflation reversal of 1967-1971 occurred as annual inflation shot from 1.6% to 5.9%, along with some pressures on the federal budget from the Vietnam War that pushed the deficit from 0.2% in 1965 to 2.8% in 1968. But even when the budget moved back into balance, Treasurys continued their rout:

The “inflation reversal” leaves bondholders particularly bruised, and is most clearly associated with fundamentals: namely a sharp turnaround in realized consumer price inflation (CPI).

Type 2: The Sharp Reversal of 1994, or the “Bond Massacre,” turned out to be short-lived. It wasn’t caused by inflation, fiscal policies, or Fed action. The Fed did begin to raise rates in May 1994, but the turmoil had started in Q3 1993 and peaked in early 1994. Instead:

[T]he dramatic increase in leveraged bond positions by both US hedge funds and mundane money managers set in motion self-reinforcing liquidations once uncertainty over emerging markets including Turkey, Venezuela, Mexico, and Malaysia – all of which experienced sharp capital flow volatility – put pressure on speculative positions.

Type 3: The value-at-risk (VAR) shock in Japan in 2003 occurred when fears spread that the Bank of Japan, which was already doing QE before it was called QE, would taper its purchases of Japanese Government Bonds. The yield curve, which had been extraordinarily flat, steepen sharply, as prices of longer-dated bonds sagged. These sagging prices hit banks, which old large portfolios of JGBs, particularly hard. Their shares crashed to multi-year lows, and some received taxpayer bailouts:

[T]he sudden steepening of the JGB curve from the middle of 2003 posed a new set of challenges: calibrated risk management structures, known as “Value-at-Risk” models, required banks to shed JGB assets once their price started plummeting. Since most banks followed similar quantitative signals, and exerted a traditionally strong home bias in their fixed income portfolios, a concerted dumping of government bonds ensued.

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