Three Arguments Against a ‘Bondcano’

One argument for not holding longer dated bonds has been that the process of normalising monetary policy globally risks triggering a ‘bondcano’.  While there is always the potential for this to occur three arguments, albeit interrelated, are put forward as to why expecting a ‘bondcano’ may be overly pessimistic.

What Does ‘Bondcano’ Mean?

A ‘bondcano’ is the scenario whereby a significant increase in bond yields occurs over a short timeframe.  The question is then, what constitutes a significant increase in yields?  To this there is no clear-cut answer, though the very term ‘bondcano’ implies an increase in bond yields which is large enough to prove disruptive to financial markets.    Accordingly, a ’bondcano’ is assumed to imply an increase in yields back to levels consistent with those in existence prior to the Global Financial Crisis of 2008 (GFC).  Such a move for Australian 10-year bonds implies a return to the trading range witnessed in the decade prior to the GFC; i.e. near doubling of yields to 5%-6%.

There are however a range of factors working against a potential ‘bondcano’ of which three are outlined below.

Cash rates : staying lower for longer

It is more difficult for bond rates to return to pre GFC levels without cash rates returning to pre GFC levels.  To better understand this dynamic, a long-duration risk-free bond can be categorised into two distinct parts:

Bond Yield = Level + Term Premium

where Level is basically the cash rate and term premium comprises a range of factors including a premium to protect against uncertainty regarding the level of future inflation.  For bond yields to move back to pre GFC levels it helps if the level of cash rates is also in line with pre GFC levels.  Given how long it has taken central banks to commence the process of unwinding QE it is fair to say it will be sometime before cash rates get back to pre GFC levels.

Central banks will avoid destabilising markets

While normalising rates will inevitably involve raising the Level of rates, central banks from the major economies will take great pains to avoid actions which may risk destabilising financial markets.  Central banks are fully aware that the process of withdrawing the monetary stimulus could have potentially negative implications for bond markets.  Reinforcing this is the interlinkage between bond and equity markets as a destabilisation in one is likely to flow onto the other; i.e. should a ‘bondcano’ occur it is unlikely that equity markets could escape unscathed.  With this being the case extreme care will be exercised by central banks to reassure markets and avoid surprises throughout the process of raising rates and reducing the level of monetary accommodation.  To this end the measure of success for which central bankers would most like to be measured against is not their ability to normalise monetary policy as quickly as possible.  Rather the true measure of success for central bankers will be their ability to make the unwinding of QE as interesting as watching the proverbial “paint dry” as monetary conditions are gradually “normalising” over an extended time period.

Creating a ‘Bondcano’ :  Easy in Theory But Harder In Practice

Theoretically the most likely scenario under which a ‘bondcano’ could unfold is that central banks around the world effectively lose control over inflation; i.e. find themselves way behind the inflation curve.  Should investors become convinced that the inflation genie is well and truly out of the bottle then they will factor in (a) materially higher cash rates and (b) require a materially higher term premium due to an increase in the level of uncertainty regarding future inflation.  This scenario would create a double whammy for bond yields.  The key however is that the expected increase in inflation needs to be high enough so that central banks will feel compelled to raise cash rates aggressively irrespective of the impact on financial markets.  Ironically the very factors needed to create a ‘bondcano’ in some ways work against such a scenario.  While there is no doubting that the demographic and cyclical factors which assisted global disinflation will diminish over time, the last 20 years have shown that in practice higher inflation and inflationary expectations are materially harder to create than expected.

It is intuitively appealing to expect that as central banks continue normalising monetary conditions then bond rates should move back to the levels seen prior to the GFC.  Unfortunately, even after nearly a decade of economic recovery, the underlying global environment is still some way off from returning to pre GFC conditions.  Against such a backdrop, while there are solid reasons for arguing that bond yields may drift higher over time as monetary policy in the major economies is normalised, a ‘boncano’ is not an inevitable outcome of monetary policy normalisation.