The media hype is for a sharp sell off in the bond market. Some “gloom and doom” pundits are even predicting a crash that will plummet the world into a worldwide depression. The US Federal Reserve has ended its $4.5 trillion bond purchase program. Fed Chairperson, Janet Yellen, has maintained a “stead as she goes” policy without a definitive time frame for raising rates. This has left analysts in a state of suspended animation.
Logic is telling us that interest rates should rise and prices fall sharply (When rates rise prices fall). However, your normal thought patterns go out the window in this topsy-turvy finance of world economies. What is up is down and vice versa. We are actually seeing a “drop” in bond yields to record lows.
Why do we have this paradox? The Central Banks of the United States, Europe and Japan are desperately trying to re-inflate their economies and bring them to a 2% inflation threshold. In the United States the Fed is stubbornly preaching that inflation is still below 2%. However, except for a drop in gasoline prices, we know that prices, especially for food, shelter and services have far outstripped the 2% barrier. Analysts see this and forecast a rise in rates in 2015. Median estimates are for the benchmark 10- year note yield to rise to 3.24% in 2015. This is the number that most investors are expecting.
Now let’s take this “smooth as silk” forecast and turn it inside out. Enter the law of “supply and demand.” The Central Banks of Europe and Japan are in desperate straits to raise cash. They do this by issuing more bonds. Japan is now in recession and sees its only salvation is to raise more money to keep stimulating their economy. The Bank of Japan expects to up their bond purchases by 20% and even up to 50% by 2018. European Central Bank President Mario Draghi is planning a QE program for Europe. The ECB expects to issue $400 billion and the Bank of Japan $700 billion. At first blush you would expect this to be a drag on prices with rates rising substantially. However, on the demand side we expect bond purchases to exceed supply. In total, we are looking at a worldwide bond market of $100 trillion. Worldwide borrowers are expected to issue $2 trillion. On the demand side Central Banks and investors world- wide are looking to spend $2.4 trillion. That leaves a shortfall of $400 billion. In addition to Central Bank buying you have pension funds, insurers and bond funds as active buyers.
The picture we have now is quite different from “gloom and doom” forecast of a bond bubble bursting. At some point the market will run out of buyers. This would trigger a panic wave of selling. Always remember that is a lack of buyers that triggers a sell off. Bids are lowered then more selling comes in and you have a full-scale sell-off. It will come when investors lose faith in their government’s ability to pay its debts. All of this paper will go up in smoke.