20 September 2019
US Federal Reserve chair Janet Yellen has warned that stocks and bonds are richly valued, triggering a bond sell-off. Photo: Bloomberg
US Federal Reserve chair Janet Yellen has warned that stocks and bonds are richly valued, triggering a bond sell-off. Photo: Bloomberg

Is the next financial crisis coming soon?

It’s still safe for investors to bet on Hong Kong and mainland stocks as Beijing is poised to pump more money into the market in the short run. However, that does not necessarily mean the equity markets are isolated from the external environment.

The yields of foreign government bonds have spiked recently, which could be a prelude to another financial crisis.

Most investors were puzzled over the negative yields of short-term government bonds earlier this year. However, things changed rapidly in late April.

The yield for a 10-year eurozone bond surged eight times to 0.675 percent from a record low of 0.075 percent. Also, US Treasury yields climbed to 2.28 percent earlier this week from a bottom of 1.86 percent in early April.

It’s quite odd for yields of government bonds to spike so sharply within such a short period.

As we know, major central banks have bought several hundred billion dollars of government bonds through their quantitative easing programs after the financial crisis. As a result, the market supply of government bonds — of short-duration bonds, in particular — has fallen back substantially.

In fact, the net issuance of government bonds has been on the decline since 2009 as central banks in the United States, eurozone, Japan and Britain all adopted QE programs.

As of early this year, the net issuance even dropped to negative territory, which means some central banks were buying more bonds than they are selling.

Meanwhile, the US dollar has been gaining strength since the second half of last year after the US Federal Reserve wound up its tapering. The move has accelerated the price correction on commodities — oil, in particular — which in turn fueled deflation risk across the world.

And the break-even rate for bonds in various nations also retreated from their peak level, or even touched the negative territory in certain countries. That reflects market expectation of weakening inflation and potential deflation.

Capital has continued to flow into bonds given the lackluster economic recovery in the eurozone and Japan coupled with mixed picture in the US. And the yields of short- to medium-duration government bonds have been weighed by limited supply and robust demand.

Also, investors have been forced to buy long-duration government bonds and even high-yield debt given that major central banks have already snapped up available short-duration bonds. As a result, yields of short-duration bonds eased to below zero, and those of longer-duration bonds also touched record lows.

The bond market has seen hectic trading as major central banks continued their intervention in a bid to brighten the gloomy economic outlook.

However, the US dollar started to ease in early April, while crude oil price rebounded by more than 40 percent, thus raising expectations for inflation.

The improving economic outlook in the eurozone, together with warnings issued by Fed chair Janet Yellen about the high bond valuations, triggered a bond sell-off.

The spiking bond yields also highlight a structural issue, the trade liquidity risk in the bond market, which leads to a policy paradox for the Fed.

The market is flooded with liquidity as central banks undertook QE programs and adopted a zero interest rate policy. This abundant liquidity has inflated the prices of various asset classes and created several crowded-trading markets. The bond market is one of them.

If the Fed opts for normalizing the interest rate, it could trigger a massive sell-off of bonds.

However, sellers may struggle to find sufficient buyers for lack of liquidity, which might lead to a repeat of the AIG case in 2009 and trigger a new and broader financial crisis.

The article appeared in the Hong Kong Economic Journal on March 13

Translation by Julie Zhu

[Chinese verison 中文版]

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Hong Kong Economic Journal chief economist and strategist