BOND MARKET CRASH AND THE CONTAGION EFFECT

BOND MARKET CRASH AND THE CONTAGION EFFECT

The prices of long-term government bonds have been trading at high levels during the last years (implying that their yields have been very low). In the United States, the 30-year Treasury bond yield has reached a record low of 2.25% on January 30.

Despite the fact that this yield has recently moved slightly higher, it remains exceptionally low. It is almost impossible to provide an explanation as to why investors carry on placing their savings in these 20 or 30 years bonds in order to earn a mediocre return which is close the Fed’s 2% target rate for annual inflation. But the bond market is fragile at the wake of an interest hike and could undergo a major correction. Consequently, the investors are worried as to whether this correction could turn into a crash which in turn would bring down the housing and the equities altogether.

Market participants in the housing and equity markets tend to set prices with a view to prices in the bond market. Thus, a contagion from one long-term market to another seems to be likely...

In theory, long-term rates in the US bond market should be even lower because of the very low levels reached by the inflation and the short-term real interest rates (close to zero or negative). In today's environment, the impact of the quantitative easing which has been incepted in 2008 should have translated into lower long-term rates but it is the opposite now.

A crash in the bond market can only be possible under two conditions: a sharp tightening of Fed's monetary policy through a hike in the short-term interest rates or a dreadful rise in the inflation.

Bond-market crashes are rare but not dramatic. Consequently, one has to look for a possible event that may ignite a crash in the long-term bond market. But the threat lies somewhere else: private bonds.

During the low interest rate environment, companies have built a substantial long-term debt in the liabilities by issuing bonds massively in order to finance their investment projects. As long as their IRR stays above the interest rate, they load their long-term liabilities with bonds. On the eve of a Fed's interest rate hike, the whole picture will start to reverse and those companies will have to roll-over their bonds with higher interest rates which may cause a wave of default. This, in turn, will spread over the equities and we may actually see the dreaded erosion of the assets.

After all, the investors who lose in one of the assets will try to limit their loss by moving in than out of the stock market. We have seen this before in 1929 where the real-estate bulbs burst in 1928 and the investors rushed to the stock market with the related consequences. Same held true in the 1973-1974 crash and 2006 house bubble which triggered the 2008-2009 crash. Anyhow, such a crash should start towards the end of this year or early in 2016 and may last well into the first half of 2018. In such an environment, the initial correction may be 20% - 30% range but the rest will follow up thus turning it into a crash with a total correction of more than 50% at its depth.