Podcast Summary
Historical bond market sell-offs and their implications: Investors and financial professionals need to be prepared for potential shifts in the bond market, as a prolonged sell-off could have significant implications for banks, pension funds, and individual investors.
The bond market, the largest financial market in the world, has been experiencing a significant sell-off after a prolonged bull market. This sell-off has raised questions about whether the bull market has come to an end and what the implications could be for investors. The stakes are high, as not only banks with Value at Risk (VAR) models, but also pension funds and individual investors could potentially face significant losses if the bond market downturn continues. Paul Schmelzing, a PhD candidate at Harvard University and a visiting scholar at the Bank of England, recently wrote about historical bond market sell-offs and their implications. While it's unclear whether the current sell-off signals the end of the bond market bull market, investors and financial professionals need to be prepared for potential shifts in the market. Principal Asset Management, a real estate manager, emphasizes the importance of a 360 degree perspective and local insights to help identify the most compelling investing opportunities in this ever-changing market. Stay informed and make informed decisions. For more information, visit principalam.com. Investing involves risk, including possible loss of principal.
One of the longest and most remarkable bond market bull runs: The current bond market bull run, which started in 1981, is one of the longest and most significant in history, with a cumulative yield compression of about 1200 basis points, and the US Treasury currently holds the title of risk-free asset.
The current bond market bull run, which started in 1981, is one of the longest and most remarkable in recorded economic history, with a cumulative yield compression of about 1200 basis points. The risk-free rate, currently held by US Treasuries, reached an all-time low of below 140 basis points in July 2022. Historically, there have only been two other bond market bull runs that surpassed this length and yield compression – one in the 1400s and another in the late 1500s to early 1600s. However, the downside of such prolonged bull markets is that they are often followed by significant sell-offs. The nature of these sell-offs is a topic for further discussion. Regarding your question, Joe, yes, throughout history, there has always been an instrument considered the risk-free asset of its time, starting from the Italian city-states of Venice and Genoa in the late 1200s, and progressing through the Dutch and British eras. The US tenure currently holds this title.
The origins of the risk-free asset concept in Venice: The concept of a risk-free asset can be traced back to Venice, the most reliable credit provider in Europe during the Middle Ages. However, determining the risk-free rate was complex due to geopolitical events' influence on bond markets.
The concept of a risk-free asset has a long history, dating back to the 13th century and the Italian city-states, particularly Venice. These city-states were considered the most reliable providers of credit and served as the reference point for interest rates throughout Europe. However, before the development of reliable secondary markets, determining the risk-free rate was more complicated. Historical bond markets were often influenced by geopolitical events, such as wars, which could result in major reversals. For instance, the Venetians' struggles with the Ottoman Empire in the 15th and 16th centuries led to the end of several significant bull markets. It's important to note that before the 20th century, central banks did not intervene actively in the markets, and political developments played a significant role in determining market trends. While we must be cautious when extrapolating historical trends to modern markets, understanding these historical dynamics can provide valuable insights into the factors that drive market reversals. Therefore, it's worth examining specific case studies from the 20th century and beyond for a more accurate comparison to today's markets.
Historical bond market sell-offs and their causes: Understanding historical causes of bond sell-offs can help investors anticipate current market trends and potential risks
While historical bond market sell-offs were often triggered by concerns over an issuer's creditworthiness, modern sell-offs have different dynamics. The discussion highlighted three case studies from the 20th century: the inflation reversal in the late 1960s, the 1994 bond massacre, and the European crisis in 1993. In the late 1960s, a combination of fiscal expansion and a tight labor market led to high inflation, which is a relevant parallel to today's economic backdrop. The 1994 bond massacre, while often linked to a Fed funds hike, was actually precipitated by the European crisis in 1993. Modern bond sell-offs can be driven by various factors, including geopolitical tensions, inflation, and economic instability. Understanding these historical dynamics can provide valuable insights into current market trends and potential risks.
Bond market crises: Past and potential future: The current bond market environment may face a crisis worse than the 1994 Bond Massacre due to similarities with past crises, including quantitative easing and yield curve flattening, despite no significant fundamental changes since the 1990s.
The current bond market environment may face a crisis worse than the 1994 Bond Massacre. The speaker highlighted instances of emerging market volatility in Mexico, Turkey, and Venezuela, which led to the failure of leveraged bets and caused significant losses. He also discussed the Value at Risk (VAR) shock in Japan in 2003, where banks had to sell their holdings due to internal models suggesting maximum losses, leading to a massive dumping of bonds. These events share similarities with the current environment, such as quantitative easing and yield curve flattening. The speaker emphasized that these bond market sell-offs can be categorized into three types, with the 1994 Bond Massacre being the most commonly referenced. However, he warned that the current situation may result in a crisis even worse than that one, as the fundamentals have not changed significantly since the 1990s.
Significant losses for bond investors due to market conditions: Bond investors face potential losses of up to 40% in real terms due to higher inflation, steepening yield curves, and bank balance sheets.
The current market conditions could lead to significant losses for bond investors, potentially surpassing those seen during the inflation reversal in the late 1960s and the steepening scenario in Japan during the early 2000s. The combination of these factors, including higher inflation, steepening yield curves, and bank balance sheets, could result in a perfect storm in the bond market. This scenario, which is a blend of factors that used to occur in isolation, could lead to losses of up to 40% in real terms for bond investors within a few years. While some investors and experts have raised concerns about this potential scenario, regulatory bodies, such as the Bank of England, have yet to publicly respond. However, it is crucial that regulators are aware of these trends and the historic price distortions in the market.
Bond markets could face a once-in-800-year event: Banks' increased home market bond holdings, meant to make them safer, could instead worsen a potential sell-off. Safe haven assets like US treasuries can still lose value, and regulations vs market conditions is a significant theme to watch.
The current situation in the bond markets could be a once-in-800-year event, and we should pay more attention to it than we have so far. Paul Schmelzing, a PhD student at Harvard and visiting researcher at the Bank of England, warns that the increased proportion of banks' portfolios based on their home market bonds, which were intended to make them safer after the 2008 financial crisis, could instead exacerbate the problem if there's a big sell-off. Safe haven assets, such as US treasuries, can still lose value in various ways, and the tension between regulations and market conditions is a significant theme to watch for in 2023. Schmelzing's work provides valuable insights into potential downside scenarios that are relevant to traders and investors right now, as yields have jumped significantly since the summer and bonds sold off after the US presidential election.
New podcast 'Money Stuff' announced, spin-off from Matt Levine's finance newsletter: Matt Levine and Katie Greifeld will discuss finance news and related topics weekly on 'Money Stuff' podcast, available on major podcast platforms
Tracy Alloway and Joe Weisenthal, the cohosts of the Odd Lots podcast, are announcing a new podcast called Money Stuff. This podcast is a spin-off from Matt Levine's popular Wall Street finance newsletter of the same name. Every Friday, Matt and Katie Greifeld, another Bloomberg TV host, will discuss finance news and other related topics in depth. Listeners can tune in to Money Stuff on Apple Podcasts, Spotify, or any other podcast platform. This new podcast is sure to provide valuable insights and analysis for those interested in the world of finance.