Tide may be changing where markets are concerned

The Everything Bull Market may be losing one of its things.

In the aftermath of the Great Recession, central banks worldwide called every option in their monetary playbooks — plus a few seemingly drawn up in the dirt — to ward off a global depression and support a substandard recovery.

According to JP Morgan Asset Management, the 50 largest central banks cut rates nearly 700 times between 2008 and 2016. Combined with large-scale bond-buying programs, the resulting sea of liquidity floated virtually all asset boats.

Among the notable beneficiaries of central bank largess were the government and corporate bonds that already were a quarter-century into bull markets of historic proportions. As government bond yields declined from 15% in 1981 to below 2% in 2016, fixed-income investors pocketed annualized gains averaging 8%, or 3 percentage points above their long-run average.

Meanwhile, increasingly puny yields in the fixed-income sector drove torrents of investor dollars into stocks, sending equity market valuations to the high end of their historic ranges.

In recent weeks, however, yields on U.S. government debt have shot higher, pushing through a key resistance level at around 2.5%. Though the end of the 36-year old bull market in bonds has been called many times before, the latest warnings do not seem like a false alarm. Economic growth worldwide is above-trend and the U.S. labor market is near full employment. Strong wage pressures already are evident in urban areas along the U.S. West Coast.

Last month’s passage of a $1.5 trillion fiscal stimulus package, combined with the recent rise in bond yields, could signal that the nine-year-old economic expansion has entered its final stage, a period during which stock and bond prices usually go their separate ways.

Initially, a drop in bond prices (and corresponding rise in yields) can be healthy, assuming it reflects faster economic growth, not faster inflation. Later, however, yields generally push higher as inflation accelerates and the Fed moves more aggressively to contain prices.

How far, how fast is key

Investors already have begun hedging their bets, with break-even rates on Treasury Inflation-Protected Securities (a proxy for inflation expectations over the next decade) having risen from 1.18% in early 2016 to 2.05% this month, or spot-on the Fed’s inflation target.

Based on the Fed’s preferred metric, current inflation remains about a half percentage point below its 2% goal. Despite reasons to think inflation should be picking up, incoming Fed Chairman Jeremy Powell seems willing to wait for clearer evidence before moving faster to normalize monetary policy.

The question of how far and how fast rates will rise is key; market expectations currently range from as few as one to as many as four increases in 2018, with the Fed clinging to its promise of three such quarter-point hikes.

Years of easy money has enabled the S&P 500 to go the last 400 trading days without a drop of at least 5%, the longest such stretch of tranquility since the 1920s. The equity market’s 6% rise over the first three weeks of 2018 represents a pay-it-forward reflection of the estimated 5% to 10% boost to corporate profits directly attributable to the recently enacted tax plan.

With investors confident that monetary and fiscal policy-makers still have their backs, stocks have entered a melt-up phase reminiscent of the late 1990s. Previously bearish equity investors have capitulated and newly jittery bondholders have reallocated — and understandably so. The last three times the Fed aggressively raised interest rates — in 1987, 1994 and 1999 — government bonds lost an average of 7% per year.

Even if short-term interest rates don’t rise faster than expected, the Fed and central banks in Europe and Japan are intent on scaling back or ending bond-buying programs that have kept long-term yields well below their historic averages. As the monetary tide begins to recede, rates are virtually certain to rise, especially as supply constraints become evident in labor and product markets worldwide.

Everything Bull Markets are unusual, and the demise of this one doesn’t necessarily portend a severe decline in bond prices. It does indicate, however, that the monetary tide is going out and that before long, all asset classes will be responsible for floating their own boats.

Tom Saler is an author and freelance journalist in Madison. He can be reached at tomsaler.com.