After a tumultuous week on major stock markets (the Dow Jones index fell by more than 1,000 points in a single trading day), stock prices rebounded somewhat. But the damage on credit markets is irreversible. Despite the fact that, for now, it seems that the correction was short-lived, this was only a taste of what is coming. Interest rates, both short-term and long-term rates, are on the rise and the “junk bond” market is starting to implode. It appears that the floodgates have been opened …
Let us first of all take a glimpse into the 10-year US Treasury rate. In the U.S., the 10-year rate rose from 2.1% to 2.9% (blue curve) in just six months. Many analysts say that this due to increasing inflation expectations. Inflation is good, so goes the idea, since it signals healthy economic growth. Yet inflation expectations (red curve) went, despite a slight increase, over the same period from 2% to a mere 2.3%. Not a particularly impressive increase; the 10-year rate rose much more than that, namely, three times as fast. Moreover, since February 1st, the 10-year US Treasury rate stubbornly continued to increase, whereas 5-year inflation expectations have dampened somewhat. Inflation is therefore not the correct explanation behind the recent increase in long-term interest rates.
The blue curve is the 10-year US Treasury rate; the red curve is the 5-year inflation expectations. Interest rates experienced a much sharper increase than the (expected) future inflation. Source: St Louis Fed
Yet short-term interest rates are no exception. Short-term rates are rising just as fast. Until the beginning of this month, short-term rates even rose faster than long-term interest rates (as a result the yield curve flattened somewhat, something we have pointed out on earlier occasions). As recent as six months ago, the 2-year US Treasury rate (blue curve) stood at approximately 1.3%. In less than half a year, the 2-year rate rose to 2.2% in February. The 2-year rate then fell somewhat over the past two weeks, but seems to have found its way back up. The 2-year rate is on the rise again and reached again 2.2%, but is bound to rise more.
The recent increase in interest rates is even more pronounced in the 12-month US dollar LIBOR (green curve), the rate that banks charge each other. This 12-month rate rose from 1.7% to 2.3% over the past six months. However convincing, we ought to observe that the 2-year (government) rate is increasing less rapid than the 1-year and 3-month LIBOR (interbank market) rate (red curve). This implies that shorter-term interest rates (in this case the 3 and 12-months rates) are rising at a faster pace than longer-term interest rates (in this case the 2-year rate). This means rather bad news for the economy. In a truly positive economic scenario, long-term rates should rise faster than short-term rates (and thus steepen the yield curve).
The blue curve is the 2-year US Treasury rate; the green and red curves are respectively the 12-month and 3-month US dollar LIBOR (source: St Louis Fed).
The so-called high-yield bond mutual funds, for which I have warned on several occassions, are suffering enormous redemptions. According to the Financial Times, last week roughly $10.89 billion dollar was pulled out of these type of high-risk bond funds, the second largest outflow since EPFR Global began tracking the data.
These “junk bonds” are simply bonds of risky, highly leveraged businesses, which due to increasing interest rates are faced with increased borrowing costs as soon as they have to refinance their debts. Precisely these overleveraged companies will be the dominoes that will fall first. The Financial Times wrote the following:
“Investors stampeded out of junk bond funds in the past week, driven by investor concerns about interest rate increases and a rise in risk aversion.”
I wrote earlier that many retail investors invest in such junk bonds through Exchange Traded Funds (ETFs):
“Savers, desperately looking for yield, pick 'junk bond' funds because they seem to offer attractive yields. Less risky bonds currently have low, or even non-existent, nominal yields. As a result, the nominal returns (6%) on these junk bond ETFs look like a gift from heaven.
An ETF, or exchange traded fund, is as liquid as its underlying assets. And when things go wrong; 'junk bonds' become illiquid very easily. When everyone wants to sell, and when the issuing companies of these 'junk bonds' go bankrupt in large numbers, the market dries up and it becomes impossible to get rid of them without incurring huge losses. The result? Some of the most spectacular losses ever seen in bond markets.”
These first initial cracks in credit markets coupled with the extreme overvaluation of stock markets are a recipe for disaster. Higher interest rates will have little mercy for stock prices. The crash of two weeks ago is therefore just a reminder of what is still to come.
The record low volatility of the past few years was just the calm before the storm. Better yet, the historically ultralow volatility suggests that the risks of enormous losses are even greater. This is what Nassim Taleb demonstrastes with his “fat tails” in probability distributions. Take the following probability distribution:
We can observe two things:
- The tails (the lef tand right extremes of the curve) are bigger in a so-called fat tail distribution. This means that the odds of extreme price fluctuations are higher than a so-called normal distribution (Gaussian distribution) presupposes (the Gaussian distribution is the base model of almost all financial analysts and economists).
- The center of our “fat tail” probability distribution is higher and “pointier” than a normal distribution. This means that the odds (under a “fat tails” distribution) of small and mild fluctuations are larger. However, by increasing the peak (center) and increasing the tails, the probability of in-between price variations is smaller.
In other words, the bigger the “tails” (and, as a result, the bigger the odds of a crash), the lower volatility will be (odds of smaller variations). This appears contradictory but is not. We are simply being fooled. While we assume that lower volatility means less risk, it in fact means more risk, because we think that variance in financial asset prices (stock prices, for instance) follow a Gaussian distribution, whereas in fact they follow a “fat tail” distribution.
Do not be fooled by the artificially low volatility of the past few years. If we know one thing for sure, it is that volatility clusters at certain specific moments in time. And last week was therefore a slight taste of what is coming. The ultralow volatility means that risks are greater, not smaller. Ben Bernanke’s “Great Moderation” (period of low volatility that allegedly proves that central banks “learn” and “become better” in managing the monetary economy) will undoubtedly be followed by a shock without historical precedent.
The fact that the XIV (the inverse of the VIX volatility index) blew up
can be rightly called a warning shot. Brace yourself. Plenty of volatility is yet to come.