This could be the beginning of the end for the market bubble

Allister Heath

COULD this be the big one, the start of a massive, seismic shift in the financial markets as the bond bubble finally starts to burst, the crash that ushers in the next phase in the world economy’s uncertain journey?

I wish I knew but it is too soon to tell. The bloodbath could go on for months – or the markets might temporarily bounce back again if the authorities promise to be nicer to them, and to give them more of the easy money they so desperately crave.

But the events of the past few days have been dramatic and far-reaching. Investors are finally beginning to realise that central banks could be about to turn the taps off, or in the Fed’s case finally reduce its $85bn a month of quantitative easing, and are starting to panic.

The fact that some parts of the global economy, including China, are slowing – paradoxically, at the very time that the UK is doing better – is adding to the concerns, and Abenomics, the widely over-hyped set of policies being introduced in Japan, is being viewed more realistically.

The result has been a sudden, partial return to reality. Bonds – including junk – have taken a battering, and so have equities and many currencies. Real yields on 10-year US Treasuries turned positive for the first time in 18 months yesterday; astonishingly, investors now want to be paid for lending money to the US government, rather than the other way around. Long may that continue: the present price of money is extraordinarily distorted by government intervention and is proving deeply damaging to the capital structure of the global economy, leading to a massive misallocation of resources.

More worryingly, emerging market equities are down by over a tenth since their peak; currencies including the Brazilian real have been hammered. All of these had been propped up by QE; the excessive liquidity from the US and Europe had been filtering into emerging market assets, which have also been supported in some cases by carry trades. Gold has also fallen back in value again: this is a correlated fall in all asset classes, with very few hedges available.

None of this is a surprise: it was bound to happen eventually. Bond markets in particular have been indulging in an ever-greater bubble for years now, and remain massively, almost laughably, over-valued even after the correction of the past few days. A 1990s-style bond market crash is inevitable. What is pathetic is that so many investors have grown so used to being mollycoddled by unending injections of liquidity that they can now barely cope and are pleading for more time from the Fed.

Sadly, the history of the past few years, starting in the late 1990s, is that of a succession of bubbles, each intended to ease the problems caused by the previous one. The authorities’ fear of ever going cold turkey has been the key factor keeping the sorry show on the road. The good news is that we may finally be nearing the moment of truth when markets start to return to their senses; the bad news is that the transition will be hugely painful.

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