Opinion: The stock market is in trouble. This is because the bond market is “very close to a crash”.

0

Don’t assume the worst is over, says investor Larry McDonald.

There is talk of a pivot in Federal Reserve policy as interest rates rise rapidly and stocks continue to fall. Both can continue.

McDonald, founder of The Bear Trap Report and author of “A Colossal Failure of Common Sense,” which describes the 2008 bankruptcy of Lehman Brothers, expects more turmoil in the bond market, in part because “there’s $50 trillion more in global debt today than there was in 2018”. And that will hurt stocks.

The bond market eclipses the stock market – both have fallen this year, although rising interest rates have been worse for bond investors due to the inverse relationship between rates (yields) and bond prices.

About 600 institutional investors from 23 countries participate in chats on the Bear Traps site. During an interview, McDonald said the consensus among these fund managers was that “things are breaking” and that the Federal Reserve will have to make a policy change fairly quickly.

Highlighting the turmoil in the UK bond market, McDonald said government bonds with 0.5% coupons maturing in 2061 were trading at 97 cents to the dollar in December, 58 cents in August and 24 cents in recent weeks.

When asked if institutional investors could simply hold these bonds to avoid booking losses, he said that due to margin calls on derivatives contracts, some institutional investors have been forced to sell and incur losses. massive losses.

Lily: The turmoil in the UK bond market is a sign of a growing disease in the markets

And investors have yet to see the financial statements reflecting these losses – they happened too recently. Depreciations of bond valuations and the recognition of losses on some of them will hurt the bottom line of banks and other institutional money managers.

Interest rates are not high, historically

Now, in case you think interest rates have already skyrocketed, check out this chart, showing the yields of the TMUBMUSD10Y 10-Year US Treasuries,
3.954%
over the past 30 years:

The yield on 10-year Treasuries has risen significantly as the Federal Reserve tightened in 2022, but it’s at an average level if you look back 30 years.

set of facts

The 10-year yield is in line with its 30-year average. Now let’s look at the evolution of forward price-to-earnings ratios for the S&P 500 SPX,
-2.37%
since March 31, 2000, which is as far as FactSet can go for this metric:

set of facts


The index’s forward-weighted price-to-earnings (P/E) ratio of 15.4 is well below where it was two years ago. However, it is not very low compared to the average of 16.3 since March 2000 or the valuation of 8.8 at the crisis low in 2008.

Again, rates don’t have to be high to hurt

McDonald said interest rates don’t need to be as high as they were in 1994 or 1995 – as you can see in the first chart – to wreak havoc, because “today , there is a lot of low-coupon paper in the world.”

“So when yields go up, there’s a lot more destruction” than in previous rounds of central bank tightening, he said.

It may seem that the worst of the damage has been done, but bond yields may still rise.

Ahead of the next Consumer Price Index report on Oct. 13, Goldman Sachs strategists warned clients not to expect any change in Federal Reserve policy, which has included three consecutive 0.75% increases in the fed funds rate to its current target range of 3.00%. at 3.25%.

The Federal Open Market Committee also pushed long-term interest rates higher by reducing its holdings of US Treasury securities. After cutting those holdings by $30 billion a month in June, July and August, the Federal Reserve began cutting them by $60 billion a month in September. And after reducing its holdings of federal agency debt and agency mortgage-backed securities at a rate of $17.5 billion a month for three months, the Fed began to reduce those holdings by $35 billion. dollars per month in September.

Bond market analysts at BCA Research, led by Ryan Swift, wrote in a client note Oct. 11 that they continued to expect the Fed not to halt its tightening cycle until the first or second quarter of 2023. They also expect the default rate to be high. – Yield (or junk) bonds will drop to 5% from the current rate of 1.5%. The next FOMC meeting will be November 1-2, with a policy announcement on November 2.

McDonald said if the Federal Reserve raised the federal funds rate an additional 100 basis points and continued its balance sheet reductions at current levels, “it would crash the market.”

A swivel may not prevent pain

McDonald expects the Federal Reserve to be sufficiently concerned about the market’s reaction to its monetary tightening to “back off over the next three weeks”, announce a lower increase in the federal funds rate of 0.50% in November “then stop”.

He also said there would be less pressure on the Fed after the November 8 US midterm elections.

Don’t miss: Dividend yields on preferred shares have soared. Here’s how to choose the best ones for your wallet.

Share.

Comments are closed.