Bond Market Calls Time on Cheap Money Era

Source: The Daily Reckoning [dailyreckoning@electricmessage.co.uk]

by Brian Durrant

Yields have fluctuated, but each successive peak in yields has been lower than the preceding one. Those peaks provide the points of contact for a downtrend line that has survived for 20 years. Traders that have bought Treasury bonds when yields were on the line made money time after time. Accordingly the line has been a source of great confidence. Such trends give traders something to hang on to.

TM2: Expectations of low interest rates makes it much easier to sell debt, since pay back rates seem affordable

But when trend that has been in place for so long breaks, there is pandemonium in dealing rooms. This is what happened in the US Treasuries market on Thursday June 7. Once the downtrend line had been crossed at the yield of 5.05% on 10-year paper, there was indiscriminate selling of US Treasury bonds.

To some traders the breaking of the trend line marks the end of an era of ever cheaper credit. Hitherto the stock market has gained enormously from cheap credit. It has made it worthwhile for companies to buy back their stock at a record rate. It has also enabled the private equity industry to go on its buy-out binge, taking out public companies at values significantly higher than priced by the market.

TM2: Blackstone’s recent share offering may not be a coincidence. It is they kind of companies that they buy out which are liable to suffer most from any credit tightening, not to mention Blackstone’s own liability. The key decision in speculative financial markets is when to activate your exit strategy i.e. pass the risk on to someone else.

Moreover the long-term optimism engendered by low stable bond yields allowed the rapid development of credit derivatives. These have made it easier for lenders to spread their risks. This in turn reduced the rates at which companies could borrow.

The last time bond yields were as high was in mid-2002 when stock markets were in free fall. In the last three months the cost of 10-year money has risen from 4.5% to a high of 5.33%. If bond market losses are compounded in the future, it will force a more widespread flight out of risky investments that have been founded on cheap money and low volatility.

Although it is too early to say that we are at the end of the four-year rally in equities, we may be at
the beginning of the end.

TM2 – It looks very like the trends are really starting to reverse.

Couple this historic cheapness with the fact that larger companies tend to have the highest dividend yields, strongest cash flows and highest return on equity and the case for shifting into mega-cap stocks
becomes quite compelling.

TM2 – Returns on these stocks will be much lower than those which traders have become accustomed to. Plus it is unlikely that these megacap stocks will be immune from the consequences of a credit squeeze.