There has been plenty of excited talk about the global “bond rout” lately but many private investors haven’t been paying attention.
Stock markets dominate their thoughts, while most ignore the big, scary and complex $76 trillion bond market.
Even a 35-year bull run couldn’t change that. Most of us leave bonds to the professionals.
But the bond market still matters, especially when threatened by an earthquake.
The aftershocks could topple a swathe of FTSE 100 stocks, among them mining giants BHP Billiton (LSE: BLT) (NYSE: BBL.US) and Rio Tinto (LSE: RIO) (NYSE: RIO.US).
Last Exit
More than three decades of declining interest rates look set to reverse, with the US Federal Reserve hiking interest rates, possibly as soon as September.
Rising rates and a return to inflation are bad news for bonds because they pay a fixed level of interest, whose value will fall in real terms.
Yields have risen and prices have fallen as worried investors head for the exits.
Small Movements, Big Losses
In the last two months, German bond prices have risen from an all-time low of 0.05% to as high as 0.83%.
That sounds small beer, and is partly a reversal of the crazy negative interest rates we saw recently, but if they were to rise to, say, 1%, that would represent a total capital loss of 9.1% from their recent low.
And if they hit 1.5%, that would equate to a 13.5% loss.
Emerging markets are the most vulnerable, especially those that have loaded up on dollar-denominated debt. If the Fed hikes rates and the dollar strengthens as a result, the cost of servicing that debt will spiral.
There are already signs of sharp outflows from emerging market debt funds.
Hard Times
China has responded with aggressive monetary easing that has sparked what may be a last-ditch stock market bubble: the MSCI China Index is up more than 20% this year.
But the underlying economy is still slowing, with GDP growth set to fall to 7% later this year, down from 7.4% last year (if you believe the official figures).
That is the slowest pace of growth since 1990.
Even if China does avoid a hard landing demand for commodities will ease as it makes the structural shift from industrialisation and urbanisation into consumption and services. It doesn’t need any more ghost cities.
BHP Billiton and Rio Tinto have replied by ramping up production and there are signs that cheaper prices have successfully driven out lower margin rivals.
That is some consolation, but if the bond rout deepens it could still leave both companies in a hole.