Blain’s Morning Porridge – September 29th 2021: What would a Multi-Sigma Bond Slide do to Markets?
“Never trust a granny on a scooter wearing a balaclava.”
This morning: The risks of Central Bank policy mistakes are escalating. Fixed Income markets are wising up to the potential of long-term stagflation/inflation. A bond correction will crush stock markets if/when real interest rates turn positive. Central Bankers will need to decide: intervene to save markets – continuing the current distortions, or let loose the dogs of market meltdown. Anyone for the last few choc-ices?
The headline in the Torygraph sums up the imminent destruction of the West: “Irn-Bru warns of disruption from supply chain turmoil.” Indeed… what clearer sign could there be, but this is the end… For anyone unfamiliar with Irn Bru: “Drink more than 50 gallons a day and you’ll rust” – its Scotland’s other national drink. Its Orange. It’s fizzy. It’s 110% sugar. It tastes of Iron filings. And, it’s a great hangover cure.
AG Barr, the manufacturers, say the problems include a scarcity of drivers and “disruption with materials, particularly aluminium cans”. The CEO added: “inflation is all around us – materials, wages and supply.. we have to be careful how we manage this.” He’s warned operating margins are going to be… impacted. If its crushing one tiny wee firm in Scotland – what’s the current economic breakdown doing to the whole economy? No doubt Wee Nicola Sturgeon will be banging on about it in Holyrood (Scotland’s toy parliament) – blaming Boris for everything.
I can’t decide what is the bigger threat?
Is it; the start of the Party Season in October without a reassuring slab of Irn Bru tins in the fridge for the morning after? Or the fact the UK, and much of Europe, is very likely to run out of Energy in what looks likely to be a very cold winter? That companies around the globe are struggling? That consumers are panicked? Might it be inflation that dooms us? Or that Central Banks might make enormous policy mistakes?
The thing about Irn Bru is … there is a cost. We Scots have about the worst teeth in the world. Our addiction to fizzy-sugary drinks destroys enamel and digs cavities in our molars. Just like the market’s addiction to frothy-ultralow interest rates has done enormous damage to the functioning of markets – stocks are addicted to it.
How transitory does inflation sound now? The reality looks to be we are into a period of sustained inflation – that’s what the numbers are now telling us. It could well become stagflation if the supply chain outages continue and push the globe into recession. (And I wrote that without mentioning China!) 5% plus inflation in the US and 3% plus in Europe. Supply chain problems are just one issue. We are seeing wage inflation also. We are about to see a massive sustained rise in Energy costs. Global Shipping costs are rising.
Is it just possible Central Banks have been talking their book when it comes to the “nothing to see here” comments about transitory inflation being a short-term phenomena? Have they been guilty of mistaking hopes of transitory inflation as a strategy? (Blain Mantra no 12: Hope is never a Strategy.)
Bond markets around the globe are… waking up to the rising threats of inflation, and trying to balance them against recession (which is good for bonds). At the moment inflation fears lead. Bond yields are spiking as investors put the parts of broken bottle back together: UK to raise rates soon. US to taper. Europe… to do nothing… rising inflation, overpriced financial assets, corrections in stocks.. I’m intrigued as to who is actualy buying bonds now – how much as central banks taking? There are certainly no massed ranks of Treasury, Gilt and Bund market makers standing ready.
In the immediate aftermath of an inflation spike triggering higher rates and weaker markets, the most likely outcome is a general decline in stocks and crashing market sentiment. I’ve been arguing for years that the main factor that’s driven disruptive tech stocks and stocks in general has been their attractive relative value to artificially distorted low interest rates. As bond yields normalise, then stocks will look less attractive.
Reading through some bank research this morning, it was warning the 26 basis point rise in US 10-year yields from 1.28% to 1/54% is roughly a 2 standard deviation significant event, and historically shifts of such magnitude are likely to trigger a stock market correction. Their argument is even more so in tech heavy stock indices – for instance the S&P 500 – which are particularly sensitive to interest rate shifts.
The brutal reality today is real yields are massively negative – 5.3% inflation in the US equates to a negative 3.76% yield, meaning the required rise in real-yields will be a “Multi-Sigma” event. If a 2 standard deviation move in yields causes triggers a sell off – what will a 13-Sigma bond sell off do to stock markets?
Ouch. The penny dropped yet?
About the best thing that can happen to bond markets now is probably a sharp stock rout. It would no doubt persuade nervous Central Bankers the global economy is so weakened by supply chains, inflation and crashing confidence, they have to step in with the CB Put and put-it-all-right again with… you’ve guessed it: more QE and artificially low interest rates.. to avoid the negative consequences of a market meltdown on global confidence. They will justify such actions on the declining prospects for employment caused by global supply chain outages triggering recession and slowdown.
The alternative is going to hurt… but a 13-Sigma Bond Crash is extremely unlikely (mainly because central banks will be forced to intervene!)
Do you see where this is going? Either the market is in for a massive dose of pain, or the distortions are set to continue. Personally, I bet on a period of further distortion to maintain post-pandemic recovery, employment, and facing up to the coming challenges of de-carbonising the global economy.
It’s going to be fascinating to hear what Central Bankers have to say for themselves in coming days. Andrew Bailey at the BOE has been the most honest – admitting rates have to rise, but still warbling about transitory inflation. Jerome Powell at the Fed is also blathering about inflation being just a spike. Christine Lagarde, politician extraordinaire at the ECB is warning about not over-reacting.
The reality is the ball is in the court of the Central Bankers. Do they bite the bullet and try to normalise rates – which will take time because a 13 sigma event to put US real rates positive will crush markets. Or do they continue to distort markets to keep them function. The risks of a policy mistake are massive.
Five Things To Read This Morning
Out of time, and back to the day job
Strategist – Shard Capital