The bond market doesn’t operate in a vacuum. The same goes for stocks, commodities and other alternative investments. Because humans are greedy and want the best returns possible, they’ll jump from asset to asset at will.
More Risk for Higher Returns
For decades, low interest rates have driven down bond yields, making it an unattractive place for investors to park their money. Instead of earning a ‘risk free’ 3%, they prefer to take on more risk for the reward of higher returns.
Some believe low interest rates have helped prop up stock markets globally. But what will happen when bond yields start to increase and investors can again earn 6.5% on their money, with little risk? While I don’t believe such a thing will happen anytime soon, it’s an interesting scenario to consider.
Citi strategist Matt King believes central bankers are completely oblivious to the likely effects on financial markets regarding their move to wind back monetary stimulus. As reported by The Australian Financial Review:
‘King said central bankers are underestimating the reaction in financial markets because they focus on the likely effect of their own relatively modest reduction in monetary stimulus.
‘But, he warned, “these policies are additive”, which means the combined effect “will be much greater than central banks imagine”.’
The US Federal Reserve is of course a chief concern for likeminded analysts such as King. The Australian Financial Review continues:
‘The US Federal Reserve has already decided to start slowly shrinking the size of its bloated $US4.5 trillion ($5.7 trillion) balance sheet and the European Central Bank is expected to announce it will reduce its monthly bond purchases. The Bank of Japan has already cut the size of its monthly bond purchases in half, following its decision to target a zero yield on Japanese 10-year bonds.’
According to King, historical evidence suggests higher interest rates could wipe 25% off global equities:
‘I think it is remarkable how, on the one hand, central banks were so enthusiastic about distorting markets, and yet how they underestimate the magnitude of the distortionary effect of their policies — how sensitive markets are to their policies’.
But if selling bonds did become a problem, would central bankers quickly reverse their actions and start aggressive monetary stimulus again?
It’s a possibility.
Interest Rates Likely to Remain Low
I suspect that central bankers will sell bonds in such a cautionary manner that it could take years for the effects to become apparent. Meaning interest rates are likely to remain low for a very long time. While this might not be great for savers out there, low interest can potentially provide opportunities going forward.
To find out what potential opportunities there are in a low interest rate environment, click here.
Junior Analyst, Markets & Money