The bond markets in the US and Europe came zooming back in 2012, with even junk issuers snatching the sort of 6 percent yields usually characteristic of normal investment grade debt. But the tells in the air are turning ominously toward a narrowing of the bond market window.
Technical factors are showing strain. The large-scale portfolio shifts toward equities that have driven the stock markets higher in the past month, despite substantial economic uncertainty, are, according to Bloomberg, driven by hedge funds piling on leverage – the most since 2004. Should the equity markets correct on the back of a government policy crisis or bad earnings season, the funds could have significant margin calls to cover. As in 2008, such a scenario, leavened with investor loss aversion, often leads to fire sales of liquid and reasonably low-risk fixed income assets.
According to Bloomberg, hedge funds are piling on the leverage because they missed out on last year’s stock market performance, and don’t want to repeat this mistake. Worse, trades that depend on prescience regarding political risk are popping up. IFR magazine says some funds are getting back into the euro convergence game – the trade that famously brought down Long Term Capital Management when today’s fund managers were in middle school.
Meanwhile banks are nervously awaiting the Basel Committee/IOSCO recommendations on initial margin on uncleared OTC derivatives. The recommendations are due out either this month or early next. A demand for such margin could sap bank liquidity, forcing them to trim credit to leveraged investors, which would spell the end of the bond market’s good times. In anticipation, private equity managers are exploring exits from their portfolio investments in bank holding companies, according to Fitch.
There appears to be a fair bit of momentum left in the bond markets, to judge from stories in the financial press about deals that set yield records on a weekly basis. Unfortunately, this could also be said of the markets in 1994, 1997 and early 2007, before those windows clattered painfully shut.