5 reasons why the bond market is selling off
1. Technical analysis
You may well disapprove of the theory that lines drawn with a ruler and a pencil on a chart of bond yields can help predict the future, but like it or not, enough people in the bond market have been looking at the 5% level in 10 year US Treasuries to make it a big deal. This marked the support trend line of the bond bull market that had gone back to 1987. The market has broken through this level, opening the way for further significant falls (if you believe in this mumbo jumbo).
2. Convexity selling
Long dated fixed rate mortgages – although less popular now than they were a few years ago – are a big part of the US property market. These are then repackaged as Mortgage Backed Securities (MBS) and sold on to bond portfolios, with cashflows from homeowners (interest payments and capital repayments) flowing through to the bond investors. Unfortunately these bonds have "negative convexity". This means that they perform badly when yields rise, and badly when yields fall – you only outperform government bonds in relatively stable yield environments. Why? Well when yields fall, the homeowner can pay back the mortgage early and remortage at a lower rate. This means that the MBS owner gets repaid, and the duration of his portfolio falls in a rallying market, making him underperform. In a bear market, as we have now, nobody refinances their mortgages as the new rates are higher. This means that the prepayment rate assumed for the investors’ portfolios is too high, and they end up being longer duration than they wanted in a falling market. As a result many will sell bonds to reduce their duration back to the assumed level ("convexity hedging") and a vicious circle can follow.
Some well known bond houses and investment banks in the US have publically changed their formerly bullish views on the market. Both PIMCO and Merrill Lynch have reversed their expectations for Fed rate cuts in 2007. Additionally former Fed Chairman Greenspan has today talked about higher bond yields being likely – a couple of months ago he was talking of the "possibility" of a US recession.
I talked yesterday about the risk of Asian Central Bank selling of their US Treasury Bond holdings. Well the market’s also worried about Chinese inflation, which has just come in at a 27 month high, albeit at only 3.4%. What really scared markets was the food component, which is rising at over 8% pa (meat and eggs showing 25%+ hikes). With Chinese living standards rising at the same time as biofuel use is raising the costs of crops, is this the start of a global inflationary food trend?
5. The economy, stoopid
US retail sales were very strong today, and economists reckon that second quarter US GDP growth will be back on track after nearly a year of sub-trend growth. Whereas Fed rate cuts were expected earlier this year, the Eurodollar futures strip now prices in a good chance of a hike by the end of this year.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.