views

BEWARE OF BOND MARKET VIGILANTES

David Morris
CFD MARKET STRATEGIST, GFT

LAST year was an extraordinary one in the markets. Following a two-month stock market plunge as investors dumped risky assets, global indices have surged since March and proved surprisingly resilient. Every time they lost momentum or struggled to break up through resistance, they got another boost. The S&P is up 63 per cent from its March low and 25 per cent on the year. There has been just a single correction of 7 per cent, over the summer. Although down for the decade, the S&P is now 28 per cent below its all-time high.

Does this seem reasonable? US economic data is improving, but from a very low base. This has been well received by the markets but it is worth remembering that much of the pick-up has been in sentiment surveys, and these tend to be bullish on the back of improving stock markets and low interest rates. The former is a bit of a self-fulfilling prophesy, while the latter can’t last forever.

Yields are pushing higher, which could be the crucial factor for investors as we kick off 2010. We can expect to see the reemergence of bond market vigilantes, who step in to check the Fed if its actions threaten to trigger inflation. By selling bonds and driving up yields (which increases the cost of borrowing) they can place restraints on governments which over-spend and over-borrow.

Many argue that inflation cannot be a problem while unemployment remains so high and capacity utilisation so low. But the vigilantes are also mindful of rising budget deficits and the unprecedented new issuance of US Treasuries. Higher yields could well be the price that the US has to pay to bridge its funding gap. Policy-makers, as well as investors, will be watching yields closely, and hoping that any moves upward won’t derail any recovery in the fragile housing market. A double-dip here could have serious ramifications.