Bank Of England Blog Warns Of Devastating Bond Market Rout, "Worse Than 1994 Massacre"

Tyler Durden's picture

First it was Goldman Sachs, which accurately warned last summer that a sharp spike in interest rates would lead to trillions in bond market losses, as observed over the past two months after the Trump election. Then it was Ray Dalio's turn to warn NY Fed staffers that "it would only take a 100 basis point rise in Treasury bond yields to trigger the worst price decline in bonds since the 1981 bond market crash." Now, it's the turn of the Bank of England, which writes in its blog, Bank Underground, that once the latest bond market bubble bursts, "it leave investors worse off than the 1994 'bond massacre'," when global bonds suffered the biggest annual loss on record.

The blog post author, Paul Schmelzing, a PhD candidate at Harvard University and a visiting scholar at the Bank of England, has little cheer for bond bulls, and writes that “as rates reached their lowest level ever in 2016, investors rather worried about the “biggest bond market bubble in history” coming to a violent end. The sharp sell-off in global bonds following the US election seems to confirm their fears. Looking back over eight centuries of data, I find that the 2016 bull market was indeed one of the largest ever recorded. History suggests this reversal will be driven by inflation fundamentals, and leave investors worse off than the 1994 “bond massacre”.

In his report, Schmelzing divided modern-day bond bear markets into three major types: "the inflation reversal" of 1967-1971, the "sharp reversal" of 1994, and Japan's "VaR Shock" in 2003. He focuses on the 1994 reversal period, when the BofA Government Bond Index tumbled 3.1% in its worst-ever annual loss as Alan Greenspan surprised investors by almost doubling the benchmark rate. Treasury 10-year yields surged from 5.6 percent in January to 8 percent in November.

Fast forward to today, when he says that a :"pessimistic reader could certainly identify gloomy ingredients for the “perfect storm”: the potential for a painful steepening of bond curves, after a sustained flattening as in 2003, coupled with monetary tightening; and a multi-year period of sustained losses due to a structural return of inflation as in 1967." As Bloomberg reminds us, last quarter was the worst for government bonds since 1987. It could get far worse, because while duration risk in 1994 was modest, it has never been greater than it is right now.

The implications: “By historical standards, this implies sustained double-digit losses on bond holdings, subpar growth in developed markets, and balance sheet risks for banking systems with a large home bias.

Which, judging by the near all time highs in the S&P, would have no impact on stocks.

* * *

Below is his full post, courtesy of the Bank Underground blog

Venetians, Volcker and Value-at-Risk: 8 centuries of bond market reversals

Paul Schmelzing is a visiting scholar at the Bank from Harvard University, where he concentrates on 20th century financial history. In this guest post, he looks at the current bond market through the lens of nearly 800 years of economic history.

The economist Eugen von Böhm-Bawerk once opined that “the cultural level of a nation is mirrored by its interest rate: the higher a people’s intelligence and moral strength, the lower the rate of interest”. But as rates reached their lowest level ever in 2016, investors rather worried about the “biggest bond market bubble in history” coming to a violent end. The sharp sell-off in global bonds following the US election seems to confirm their fears. Looking back over eight centuries of data, I find that the 2016 bull market was indeed one of the largest ever recorded. History suggests this reversal will be driven by inflation fundamentals, and leave investors worse off than the 1994 “bond massacre”.

Bond “bull markets” since 1285

Chart 1: The Global risk free rate since 1285

As a contemporary of fin-de-siècle Vienna, Böhm-Bawerk witnessed a period of unprecedented internationalization, deepening trade relations, and technological innovation – associated with the parallel financial phenomena of the expansion of London-based merchant banks, and the growth in global capital mobility(triggering the heyday of the “cash nexus”). At this point, yields on the global “risk free bond” – then British consols – had fallen to an all-time low of 2.48% in 1898 (Chart 1). But not least his own enthusiasm should prove short-lived: soon after his writing, rates entered what Richard Sylla and Sidney Homer later defined as the “first bear bond market”.

Indeed, judging purely by historical precedent, at 36 years, the current bond bull market had been stretched. As chart 2 shows, over 800 years only two previous episodes – the rally at the height of Venetian commercial dominance in the 15th century, and the century following the Peace of Cateau-Cambrésis  in 1559 – recorded longer continued risk-free rate compressions. The same is true if we measure the period by average decline in yields per annum, from peak to trough. With 33 bps, only the rallies following the War of the Spanish Succession, and the election of Charles V as Holy Roman Emperor surpass the bond performance since Paul Volcker’s “war on inflation”.

Chart 2: Length and size of bull markets since 1285

chart-2

Modern bear shock markets, 1925-2016

It thus appears timely to ask about the characteristics of bear bond markets. Since Homer and Sylla’s first bear market, on our count the United States (the current issuer of the global risk-free asset) experienced 12 modern “bond shock” years, during which selloff dynamics cost long-term sovereign bond creditors more than 15% in real price terms.

Aggregating these bear markets (chart 3), we find that, at 6.1% CPI year-on-year on average, “bond shock years” record inflation levels almost double the long-term trend, at 3.1%. Global growth equally is below average, though not in recession territory. Interestingly, during bond bear markets, US federal deficits, with 2.3% of GDP, actually fall slightly below the post-1945 average track record of 2.9%. An increase in the supply of bonds, therefore, seems not decisive to the weakening in price levels.

Chart 3: Macroeconomic outcomes in bear markets

chart-3

Bond turbulence, however, has traditionally struck investors in different shapes – especially since the time of Homer/Sylla’s first bear market. Below we present three types of modern bear bond case studies to illustrate that – while historically inflation acceleration has been a solid predictor of sharp bond selloffs – some prominent episodes appear less correlated with fundamentals, and can inflict similar levels of losses.

Type 1: The inflation reversal, 1967-1971

The “inflation reversal” leaves bondholders particularly bruised, and is most clearly associated with fundamentals: namely a sharp turnaround in realized consumer price inflation (CPI).  This  scenario correctly weighs on the minds of today’s reflationists. US bonds lost 36% in real price terms during 1965-1970, slightly outstripping losses during the 20th century’s first bear market (Chart 4). Annual CPI more than tripled in the same timeframe, from 1.6%, to 5.9%. Looser fiscal policies seem to have played only a secondary role in the 1965-70 bond sell-off, though the Vietnam War put some unexpected pressure on the federal budget. The deficit widened from just 0.2% in 1965, to 2.8% three years later – but USTs continued to decline when public finances swung back into positive territory.

Chart 4: The bear market of 1967-71

chart-4

Type 2: The Sharp Reversal, 1994

The 1994 “bond massacre” has attracted particular attention of late, and represents a second type of reversal, characterized by steep, but short-lived turbulence that is associated more with financial sector leverage and exogenous positioning – rather than macro fundamentals.

After bottoming in the autumn of 1993, US bond market yields started ascending quickly, even amid discount rates on a 30-year low. A rollercoaster performance followed, which saw bond volatility surge to levels not seen since the Volcker inflation fight. However, US bonds were firmly back in bull territory by 1995, adding 18.1% in prices after inflation.

Neither inflation expectations – which peaked at an unexciting 3.4%– nor fiscal policies, which remained on the steady Clinton consolidation path, offer satisfactory explanations for the rout. Though journalistic accounts link the sell-off with the Fed’s February 1994 decision to raise short-term rates, closer investigations suggest a loose correlation at best. As the data proves, volatility in US 10 year bonds started rising in Q3-1993, while official discount rates were only raised in May 1994 – at a time when volatility had almost peaked already (Chart 5).

Chart 5: The “Bond Massacre” of 1994

chart-5

Evidence from the financial sector rather suggests that the dramatic increase in leveraged bond positions by both US hedge funds and mundane money managers set in motion self-reinforcing liquidations once uncertainty over emerging markets including Turkey, Venezuela, Mexico, and Malaysia – all of which experienced sharp capital flow volatility – put pressure on speculative positions. Against current predispositions, it seems unlikely a sell-off today would trigger only a brief spark in volatility, and soon revert to the secular post-1981 trajectory.

Type 3: The VaR shock, Japan 2003

But as our third type illustrates, bond turbulence can be highly discriminatory across maturities. Given the latest decision by the Bank of Japan to target long-term bond yields, after a period of unprecedented yield curve flattening, parallels emerge to the 2003 Japanese curve steepening episode, sometimes dubbed the ”Value at Risk Shock” (Chart 6). Back then, markets underwent a notable rollercoaster of the term structure against the backdrop of “tapering fears” over the BoJ’s bond buying program, the Iraq War, and domestic tax hikes.

Chart 6: The Japanese bear market of 2003

chart-6

“VAR shocks” have especially deep impacts on the banking sector, whose profitability in the maturity transformation business tracks prevailing curve steepness. The dramatic flattening of the JGB term structure prior to March 2003 therefore went hand-in-hand with a sustained sell-off in the TOPIX bank index, which fell to multi year lows. Prominent financial institutions, such as Resona Group, had to be rescued through billion Dollar public bailouts.

Though the TOPIX recovered, and realized Japanese inflation only accelerated modestly, the sudden steepening of the JGB curve from the middle of 2003 posed a new set of challenges: calibrated risk management structures, known as “Value-at-Risk” models, required banks to shed JGB assets once their price started plummeting. Since most banks followed similar quantitative signals, and exerted a traditionally strong home bias in their fixed income portfolios, a concerted dumping of government bonds ensued.

Conclusions

What does the historical track record imply for current markets? A pessimistic reader could certainly identify gloomy ingredients for the “perfect storm”: the potential for a painful steepening of bond curves, after a sustained flattening as in 2003, coupled with monetary tightening; and a multi-year period of sustained losses due to a structural return of inflation as in 1967.

On the one hand, the anecdotal fear that a repeat of a 1994-type of bond crash is likely seems somewhat exaggerated, given progress on bank leverage regulations – while the current global capital flow cycle has already almost fully reversed from the cycle peak.

Type-1 and Type-3 bear markets warrant more attention. Global inflation dynamics are picking up, at a time when Central bankers voice more tolerance for “inflation overshoots”. Though currently bank equity investors are cheering the steepening of yield curves, meanwhile, the 2003 Japan episode should fix regulators’ attention on the growing home-bias in government bonds. Problematically, the IMF has warned that VAR risks have risen “significantly” in Japanese financial institutions after the financial crisis, given a continued build-up of JGB concentration in balance sheets. In Europe, the trend is equally one-directional: Italian monetary financial institutions, for instance, hold 18% of their assets in domestic government loans and securities, up from 12% in 2008. In most geographies, these bonds, despite efforts to the contrary, remain mainly held in “available-for-sale” portfolio buckets, where they have to be marked-to-market.

On balance, then, more than to a 1994-style meltdown, fixed income assets seem about to be confronted with dynamics similar to the second half of the 1960s, coupled with complications of a 2003-style curve steepening. By historical standards, this implies sustained double-digit losses on bond holdings, subpar growth in developed markets, and balance sheet risks for banking systems with a large home bias.

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venturen's picture

Looking forward to the black hole economy of 0% sucking everything in....nothing will escape. We are all spinning around the zero interest rate with nothing able to escape the event horzin...we are just beginning 

Rubicon's picture

Is Schmelzing a Muslim?

LawsofPhysics's picture

Sure sure...

the derivative "market" has to go first, then bonds, then cash...

re-establishing the correct pyramid/paradigm etc. and re-connecting money to physical reality.

...but I digress, this would imply that "fundamentals" actually mattered again.

A. Boaty's picture

Don't worry. They have it all perfectly hedged.

syzygysus's picture

Haven't heard much of Jubilee lately.  Anyone for a total wipeout?

 

 

CRM114's picture

I was BORN ready.

No, really. My mom and the midwives were quite surprised. Calm, alert, thinking. No wailing or any of that rubbish.

Mountainview's picture

The BoE with the dove of all doves at her head will lead the £ to its intrinsic value = zero

ebworthen's picture

ZIRP, NIRP, and bonds that lose you money - to chase people into the casino equity markets - which they will crash and rake Mom and Pop's chips off the green felt - AGAIN.

seektruther's picture

It comes to something when the Bank of England warns about a Bond market catastrophe and the markets shrug it off.My Channel Island contacts tell me there is now an indecent haste for the Worlds wealthiest individuals to get not only their wealth offshore but to buy property in the Islands to gain residency

LawsofPhysics's picture

One has to wonder how much food those islands can produce...

CRM114's picture

If the economic collapse I suspect is coming happens, all their debunking to other locales is just choosing where they will be lynched.

Clearly they weren't paying attention in History Class when empire collapses and revolutions were being discussed. No rich bastard makes it out the other side.

small axe's picture

The silver lining is that a couple of dozen of the architects of this absurd monetary policy will suffer massive seizures on the day the bond market goes belly up.

 

 

Muppet's picture

Always the when.

HokumYTrader's picture
HokumYTrader (not verified) Jan 4, 2017 12:57 PM

What are Bonds? we buy stawks here in Merica

Byte Me's picture

Plague in 17c Europe => bond bull market.

OK Got It

 

Sam Spade's picture

Dear "visiting scholar", Lacy Hunt begs to differ with your conclusions.

Ghost who Walks's picture

I took this article as suggesting that Banks and particularly Japanese and Italian Banks that had lots of their own Governments bonds in "mark to market" portfolios will struggle when these bonds drop in value. The author mentions "Balance sheet risk" which I guess means that the stuff which is supposed to be part of the bank's capital base will be losing perceived value and the gearing ratio will be changing adversely. 

A chart of the European Banks and their holdings of Govern Bonds as a proportion of their Capital base would be instructive.

Lazane's picture

Trump if you really want to send the message that America will be great again and leverage your Presidency, open the Gold window, Yes it would likely bring on the TW, but thats ok we can then expedite the Jubilee, reality? the party is over, its time to get about the business of making America Great Again.

 

Dr.Carl's picture

Retired after decades of being in financial industry. The only charts we need to look at come from ShepWave.  https://t.co/LM81DZlPyF

 

From their blog at www.shepwave.com/blogs 

 

ShepWave 

ShepWave Pre-Market / Intra Day Update for Wednesday Published. Markets Remain Highly Predictable even for the short term!
by ShepWave.com
Posted: 1/3/2017 17:09 EST

AGAIN, YOU JUST CAN'T MAKE THIS STUFF UP!

 

The past several weeks continue to be predictable just as 2016 was predictable in whole.

 

We saw the Trump rally work out.

 

We then saw a trading range that worked out well for those of us who go short and long on a regular basis depending on the trend channel(s).

 

I could go on and on with details of how predictable the markets have been lately; even on Tuesday (today) we saw our targets published in the pre-market nailed, and then a bearish short term reversal, but then a mid day bullish day reversal; once again to support our current short term view of the indexes.

 

The $39 One Month Subscription Special is still active but will be ending entirely shortly.

 

The $119 One Year Subscription Special is also still active, but will be raised in price beginning Tuesday most likely.

 

We are coming close to the maximum number of subscribers we prefer to have at ShepWave to ensure that we maintain our ability to give personal guidance when necessary to our subscribers.

 

We will be cutting off new subscribers by the end of January. If you are a current or past subscriber do not worry. Just email me; we will always have a spot for you.

 

Log In at www.shepwave.com for Wednesday's Pre-Market / Intra Day ShepWave Update.

 

 

10:50 AM ET USA. Intra Day Updates

 

Once again, the markets are behaving in predictable and therefore profitable patterns.

 

Yesterday one of our long-time subscribers emailed me an article about JPM saying 'that it was not a surprise that we saw a sell off Tuesday, but that the real issue is why we had the gap up in the morning.' (I am paraphrasing.)

 

I assume this article was from CNBC. I am not really sure as I did not read it that closely.

 

 

Notice how the markets did in fact rally after that, and as we anticipated put in even new higher highs today.

 

I do not rely on CNBC or any other source for such drivel. By the time these people write anything it is old news; and worse, as this example shows they are clueless as to giving any real trading guidelines.

 

Read the notes and analysis in ShepWave Updates and as in the past you will have the information necessary to give you profitable trades. 

 

Note that while we do enjoy emails from our subscribers--especially ones asking pertinent questions--we find such articles as being a waste of time. The information needed to successfully trade and invest is in the ShepWave updates: IT IS THAT SIMPLE.

 

Log In at www.shepwave.com for today's Intra Day ShepWave Updates.

 

 

Note that ShepWave is nearing its maximum number of subscribers. The current rates will be raised to limit new subscribers.In a couple of weeks we will not allow new subscribers for a period of time. If you are a current or past subscriber, do not worry. Just email me; we always have a place for you. We do this just to limit the number of new subscribers and to be able to continue giving the personal style of service we have been giving for almost 14 years.

LowerSlowerDelaware_LSD's picture
LowerSlowerDelaware_LSD (not verified) Dr.Carl Jan 4, 2017 1:52 PM

FUCK OFF, SCHLONGWAVE SPAMMER.

All, I apologize for adding to the space taken up, above, by SchlongWave's unethical spam advertising comments. PLEASE do not go to or click on SchlongWave's spam comment links. Alexa rates their web site at 768,896 globally (wow... INCREDIBLY POOR!). Currently 12.3% of their visits are coming from clicking on SchlongWave's ZH spam comments (ZH gets zero income from this). No doubt SchlongWave monitors these statistics and will keep up the spamming as long as ZHers click on their spam links, going to their site.

Any organization that uses TOS violating spam comments to advertise is an unethical organization, at best. SchlongWave has set up 15 to 20 accounts, possibly more by now, to advertise via a slew of comment spam, often times causing comment threads to become somewhat unbearable. They normally give themselves, using their set of spam accounts, MANY thumbs up, and "excellent analysis" comments in response, trying to convince people that their spam comments are appreciated.

SchlongWave, honestly, you're not going to win over the ZH crowd by spamming the crap out of comment sections, begging for $35/month from people to "subscribe." Please stop spamming ZH. Please put your time and effort into doing good analyses instead. Good results will bring in customers.

Your spam accounts have been identified as: AliSONY, Babs.St.Louis, Billy G, Chi Juan, Dr.Carl, ErikE, FemDayTrader, Irvingm, John Beau, MexInvest, MikeM54, P Christmas Carole, RonnieM, Sonya B59, StevieTexie, Van G, wisetrader224

Dr.Carl's picture

Retired after decades of being in financial industry. The only charts we need to look at come from ShepWave.  https://t.co/LM81DZlPyF

 

From their blog at www.shepwave.com/blogs 

 

ShepWave 

ShepWave Pre-Market / Intra Day Update for Wednesday Published. Markets Remain Highly Predictable even for the short term!
by ShepWave.com
Posted: 1/3/2017 17:09 EST

AGAIN, YOU JUST CAN'T MAKE THIS STUFF UP!

 

The past several weeks continue to be predictable just as 2016 was predictable in whole.

 

We saw the Trump rally work out.

 

We then saw a trading range that worked out well for those of us who go short and long on a regular basis depending on the trend channel(s).

 

I could go on and on with details of how predictable the markets have been lately; even on Tuesday (today) we saw our targets published in the pre-market nailed, and then a bearish short term reversal, but then a mid day bullish day reversal; once again to support our current short term view of the indexes.

 

The $39 One Month Subscription Special is still active but will be ending entirely shortly.

 

The $119 One Year Subscription Special is also still active, but will be raised in price beginning Tuesday most likely.

 

We are coming close to the maximum number of subscribers we prefer to have at ShepWave to ensure that we maintain our ability to give personal guidance when necessary to our subscribers.

 

We will be cutting off new subscribers by the end of January. If you are a current or past subscriber do not worry. Just email me; we will always have a spot for you.

 

Log In at www.shepwave.com for Wednesday's Pre-Market / Intra Day ShepWave Update.

 

 

10:50 AM ET USA. Intra Day Updates

 

Once again, the markets are behaving in predictable and therefore profitable patterns.

 

Yesterday one of our long-time subscribers emailed me an article about JPM saying 'that it was not a surprise that we saw a sell off Tuesday, but that the real issue is why we had the gap up in the morning.' (I am paraphrasing.)

 

I assume this article was from CNBC. I am not really sure as I did not read it that closely.

 

 

Notice how the markets did in fact rally after that, and as we anticipated put in even new higher highs today.

 

I do not rely on CNBC or any other source for such drivel. By the time these people write anything it is old news; and worse, as this example shows they are clueless as to giving any real trading guidelines.

 

Read the notes and analysis in ShepWave Updates and as in the past you will have the information necessary to give you profitable trades. 

 

Note that while we do enjoy emails from our subscribers--especially ones asking pertinent questions--we find such articles as being a waste of time. The information needed to successfully trade and invest is in the ShepWave updates: IT IS THAT SIMPLE.

 

Log In at www.shepwave.com for today's Intra Day ShepWave Updates.

 

 

Note that ShepWave is nearing its maximum number of subscribers. The current rates will be raised to limit new subscribers.In a couple of weeks we will not allow new subscribers for a period of time. If you are a current or past subscriber, do not worry. Just email me; we always have a place for you. We do this just to limit the number of new subscribers and to be able to continue giving the personal style of service we have been giving for almost 14 years.

LowerSlowerDelaware_LSD's picture
LowerSlowerDelaware_LSD (not verified) Dr.Carl Jan 4, 2017 1:35 PM

All, I apologize for adding to the space taken up, above, by SchlongWave's unethical spam advertising comments. PLEASE do not go to or click on SchlongWave's spam comment links. Alexa rates their web site at 768,896 globally (wow... INCREDIBLY POOR!). Currently 12.3% of their visits are coming from clicking on SchlongWave's ZH spam comments (ZH gets zero income from this). No doubt SchlongWave monitors these statistics and will keep up the spamming as long as ZHers click on their spam links, going to their site.

Any organization that uses TOS violating spam comments to advertise is an unethical organization, at best. SchlongWave has set up 15 to 20 accounts, possibly more by now, to advertise via a slew of comment spam, often times causing comment threads to become somewhat unbearable. They normally give themselves, using their set of spam accounts, MANY thumbs up, and "excellent analysis" comments in response, trying to convince people that their spam comments are appreciated.

SchlongWave, honestly, you're not going to win over the ZH crowd by spamming the crap out of comment sections, begging for $35/month from people to "subscribe." Please stop spamming ZH. Please put your time and effort into doing good analyses instead. Good results will bring in customers.

Your spam accounts have been identified as: AliSONY, Babs.St.Louis, Billy G, Chi Juan, Dr.Carl, ErikE, FemDayTrader, Irvingm, John Beau, MexInvest, MikeM54, P Christmas Carole, RonnieM, Sonya B59, StevieTexie, Van G, wisetrader224

Dr.Carl's picture

I am not an organization. I am Dr. Carl Cohen.

 

I gather from your post you cannot read charts, or are not in the markets to care.

LowerSlowerDelaware_LSD's picture
LowerSlowerDelaware_LSD (not verified) Dr.Carl Jan 4, 2017 2:04 PM

And I am Bond... James Bond. You believe me, correct?

FUCK OFF fake doctor and spammer. Pay for advertising on ZH. Quit posting MASSIVE spam comments, asshole.

Ah! I get it now... you are a witch "doctor" in Nigeria who can't make money other than by being paid for each spam comment that you post.

Now get busy using our other SchlongWave spam accounts to give yourself a bunch of "thumbs ups" and me "thumbs down."

Jus7tme's picture

This thing they call "steepness" or "steepening": They really mean the change in HEIGHT (also called SPREAD) of the yield curve from 0 to X duration, or between X1 and X2 duration. Of course, increased height implies increased average steepness, but steepness (dy/dx) can also be localized. In other words, "steepness" is a bit of an ambigous or wooly term. In fact, it seems that sometimes people even use it as a euphemism for moving the entire curve upwards.

I suspect the fondness for the term  "steepness" is a that it is a bit of a euphemism for higher interest rates, while sounding less alarming to those that want low interest rates (at whatever duration is in question).

Along the same lines of thought, "flattening" sometimes is used to mean literal flattening from duration 0 to X, or duration X1 to X2, but often it is also a euphemism for moving the entire curve down.

If I had my druthers, I think it would be more informative if people discussed absolute yield levels and duration yield spreads, rather than using  terms such as steepness/flatness or steepening/flattening. Of course, if someone is trying to obfuscate or hide information, using steepness nad flatness can be useful.

Sick Underbelly's picture

Could someone please explain to me the importance of "duration risk" as it's used in this quote from the article (my emphasis added):

As Bloomberg reminds us, last quarter was the worst for government bonds since 1987. It could get far worse, because while duration risk in 1994 was modest, it has never been greater than it is right now.

The graphic, below the use of "duration risk", shows average corporate bond maturity lengths at 14+ years, etc.

If I read this discussion of "duration" properly, it appears that the longer you hold a bond, the more interest rates can rise, and, as interest rates rise, the actual price of that bond will go down...effectively causing the holder to lose money.  Yes?