Rethinking Ta-Ta-Tantrums

By Cees Bruggemans

The global bond market has repositioned itself over the last few weeks, in a rather abrupt fashion, reminding of the "taper tantrum" of May/June 2013.

And there is much in common, most fundamentally that market perception of the future prospect has changed, inviting a different term structure for interest rates, higher and more steeply sloping. And this view still in its early evolving stages…

The main initiating action to this changed world view wasn't American but European, with especially the German long bond (Bund) yield lifting abruptly (for which reason it became known as the "Bund Tantrum" while some, looking wider, preferred to call it a "term tantrum", in both instances referring to an abrupt change in positioning and appearance).

This was totally unexpected, even if technically it shouldn't have been, as some bonds had become unprecedentedly overbought. Yet the prevailing view was fixated on the well-flagged ECB buying of sovereign bonds, their relative tight supply, and above all the uniform negative view of European growth & deflation prospects.

A bandwagon had come into being that had driven bond yields across Europe to unprecedented low levels, with shorter denominations and certain country paper increasingly in negative nominal territory. To the point of ridiculousness?

So skewed that when a less drastic view of events started to crystallise, one in which growth resumed (rather than recession persisting) and deflation did not vest, the broader bond market found it was wrongly positioned entirely.

With the earlier European rush to lower yield levels also communicated to the US bond market, and thereby globally, keeping yields everywhere remarkably low ("repressed" a better term?), the abrupt European turnaround in perception in turn was communicated wider, lifting its depressing influence over US and other bond market yields, and inviting a global lifting of yields.

However, many EM (emerging market) bonds did not respond as vigorously, or were hit as badly as was the case in the 2013 taper tantrum, instead this time bearing up well. This has been ascribed to commodity prices also supportively bouncing higher, much wider spreads with developed market bonds already existing, and EM currencies already having sold off strongly (these three features offering a rich risk buffer capable of absorbing some market shock).

The global bond market rerating was therefore primarily a developed country phenomenon, focused on the unwinding of their excesses.

Does this matter?

It certainly matters that Europe is not mired in sustained recession or long-term deflation and that bond yields realistically reflects this. Similarly, to the extent that bond yields were repressed artificially by European market actions relative to their own fundamentals, it is healthy that this grip has been relaxed.

At the same time it needs to be appreciated that the world had not overnight gone to the other extreme of now expecting a quick acceleration in growth or inflation, in Europe or anywhere else. Far from it.

Still the correction was enormous, for the imbalance in perception that existed earlier had become enormous. It was the fear of disappointing growth, to the point of renewed recession, and especially insidious deflation longer term, that had become excessively discounted in expected longer term central bank actions.

The European bond market till only very recently had been discounting a first ECB rate tightening only by 2021 – six years away. It was this extreme view that invited punishment, as reality wasn't close to being this bad (yet not accepted as such, until the break in market perceptions came during mid-April as new data – and thinking – surfaced).

The deeper question concerns "so what?".

The global repositioning, though abrupt, has remained orderly, with the EM universe bearing up much better than expected, given the 2013 experience.

Importantly, not everyone actually wants to call this a tantrum, as the selling did not become intense enough.

Meanwhile, the bigger part of any developed bond market adjustment still lies ahead. For starters, nominal US GDP growth of 4% (as has been the case for some time) does not warrant 2% 10-year bond yields. More bond yield lifting is to be expected as growth and inflation expectations evolve, of which this recent European event will probably prove to be only one example. More such rerating episodes (or "tantrums") likely lie ahead, as much in the US as the Fed finally starts to lift, as in Europe where longer term macro prospects may still not be adequately reflected.

Traditionally, EM space feels terribly exposed when these changes occur, and never more so than now, given the extent of likely developed market rerating still to be achieved. And yet EM may already have adjusted more than so far fully acknowledged, lessening its exposure (though not eliminating it).

SARB has stressed lately that interest rates will be focused on inflation, and that "temporary" breaching of the target zone, as again likely by early next year (off an extremely repressed base in 2015 on account of lower oil prices), likely will be ignored. Specifically, we won't be using (higher) SA interest rates to attract more foreign capital.

By implication, the Rand will have downside potential. How much remains to be seen. We have seen massive bond & equity capital outflows over the past year, yet the balance of payments deficit of over 5% of GDP (over R200bn) continued to be handsomely funded by "other" short-term capital flows.

No guarantee that this will continue but also no guarantee it will end. Something more drastic would likely be needed for that.

So, yes, Rand downside potential as global yields lift, across the full spectrum eventually as even the Fed starts to join the act, setting in motion capital flow adjustments, and our SARB on record saying it won't chase an interest rate target in pursuit of capital (and a Rand target….).

That will leave it to the market to ration our capital, and set the Rand. Our bond and equity flows will only offer a very imperfect window on this spectacle, as has been the case for the past 18 months.

So though we can see changing goal posts with our eyes wide open, there remains hope there won't be a bust. Still, come prepared to the Great Rotation now underway.

Having said all that, one notes the series of disappointing data releases of late, out of the US but also concerning global consumption. It has fed disappointment about US growth prospects, inflation revival & has pushed back the expected start to the Fed rate lifting.

This cold shower is likely to tame this particular bond tantrum ere long, if it hasn't already been effectively dozed. After that, it is waiting for a new period of uplifting data and new perceptions to set in motion the next market movement. Just like in June 2013 after that other big ta-ta-tantrum.