Have bonds reached a tipping point?

"Look at the world around you. It may seem like an immovable, implacable place. It is not. With the slightest push - in just the right place - it can be tipped." - Malcolm Gladwell

Have world bond markets finally reached the tipping point? Back in February, this column carried the following warning in its headline: "The bond market must turn sometime". And indeed, in the past three weeks, it has turned dramatically.

Was this an example of great prescience? No. This column had been warning for about a decade that the great bull market in bonds must end sometime soon. That bull market is now more than three decades old and it is still intact. The long-term trend in bond yields remains firmly down.

Second, it remains quite possible that this latest incident is not a tipping point.

True, German Bund yields have enjoyed a spectacular reverse, giving up five months of gains in a matter of days. But this only brings them to levels lower than ever seen before December last year. They still signal deep negativity about the German and eurozone economies.

Many false "tipping points" preceded this incident - most recently the "taper tantrum", when yields shot up around the world in May 2013 after Ben Bernanke of the Federal Reserve speculated about "tapering off" bond purchases made under its quantitative easing programme.

A third problem for anyone who likes to call history to their aid is that this time is undeniably different.

Usually these words spell disaster. But we have never before seen the European Central Bank resort to QE bond purchases, while in the US the Federal Reserve has never before tried to return its policy to normal after a dose of QE.

It is also hard to find a precedent for the state of regulation. During the last decade, liberal regulation made it easier for large banks to trade bonds, ensuring a liquid market. Liquidity, as measured by total volumes, is retreating, although it remains higher than a decade ago.

Neither those who argue that rate rises could lead to severe market disruption, nor those who pooh-pooh such claims, can cite any historical evidence.

But it is not too difficult to work out what has just happened. This reverse started in Germany. Yields on German Bunds moved in line with US Treasuries until late in 2012, when Bund yields started to dip lower - and helped pull US yields down with them.

Bund yields' relative decline came after the worst of the eurozone crisis was over. Instead, judging by the implicit forecast for inflation derived from inflation-linked bond markets, it reflected fears about deflation in the EU. That fear became extreme when Bund yields went negative earlier this year.

Why the deflation fear? The economy was slowing and investors did not trust the ECB to act to stimulate the market. Once deflation fears reached a peak, the ECB folded and unveiled QE bond purchases. This pushed up inflation expectations (as it was supposed to do). Bond yields stayed lower for longer - as the ECB was pushing them down by buying bonds - but in the past few weeks, as investors decided the deflation scare was over, yields shot back upwards.

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How could this change? First, look at the market itself. It has been febrile of late and many use leverage - borrowed money - to buy bonds. That opens the possibility of cascading losses if bond prices continue to fall. We need to see whether this turns into a self-perpetuating sell-off.

Second, the Fed. Even if the ECB started this sell-off, the bond market's ultimate direction will be fixed in the US. The Fed wants to raise rates, and might do so as early as next month.

History suggests that the way the Fed raises rates, once it does, is critical. Take two episodes when Alan Greenspan was in charge. In 1994, rates rose swiftly, against expectation, and drove up longer term yields while keeping the stock market flat.

A decade later, when departing the low rates that had eased the bursting of the dotcom bubble, Mr Greenspan did it differently. Interest rates rose by well-telegraphed increments of 0.25 percentage points at every meeting the Fed held for years. Long-term yields actually fell, while stocks enjoyed a "fools' rally".

Both had their disadvantages. In 1994, the bond market ructions led to the Orange County bankruptcy, and to the chain of emerging market crises that started with Mexico's devaluation at the end of that year. It also laid the way for the Clinton boom as both markets and the US economy roared ahead.

In 2004, the softly-softly approach averted trouble in the short term, but helped ensure that the huge speculative build-up in credit went unchecked - leading to epochal crisis in 2008.

The forces pushing down on yields remain. Institutions are under pressure from regulators to buy bonds, while continuing low inflation justifies low yields. This sell-off may turn out to have been a tipping point, but only if market liquidity proves even poorer than many fear - or if the Fed forces the issue.

One final question might be whether this all matters. It does. Long-term interest rates drive the economy. They set the cost of capital for those who want to invest, making them the bedrock of the pricing of almost any financial transaction. Sharp rises should be expected to choke off investment.

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