Long predicted bond market reset may have begun – J.P. Morgan Asset Management

11th June 2013

Below is the latest note from J.P. Morgan Asset Management’s Dan Morris who argues that we are still a long way off the target unemployment rate which should see the tapering of quantitative easing, but when it comes it will have a big impact given that the end of QE1 and QE2 saw big market falls.

After a nervous couple weeks, US equity markets reacted positively to the latest payrolls report. Outside the US, however, markets were down from the previous Friday (see table above). Some of the current market volatility could decline following the US Federal Reserve (the Fed) chairman’s press conference this month if Bernanke provides a clearer indication of timing for a tapering of the Fed’s asset purchases. The hope for certitude may be disappointed, however, as the guidance from the Fed may be: ‘It depends.’ One of the benchmarks for less aggressive monetary policy is strong employment growth and a target unemployment rate of 6.5%, but that is still a long ways off. On current trends, we forecast the unemployment rate will not hit that level until next year, and there is a wide range around the date depending on the rate of job creation and the labour participation rate (see Figure 1).

Figure 1: Fed target unemployment rate scenarios


Last data May 2013. Note: Current payrolls assumes monthly non-farm payrolls increase by 150k and participation rate is constant at 63,5%. Improving payrolls assumes increase in non-farm payroll rate to 200k/month and participation rate increases by 0,05% each month. Deteriorating payrolls assumes increase in non-farm payrolls of 100k/month and participation rate dropping by 0,05% each month. Source: BLS, US Federal Reserve, J.P. Morgan Asset Management.

Once quantitative easing (QE) ends, what is the likely impact on equity markets? To judge by the returns when QE 1 and QE 2 ended, it could be a correction of more than 10% (see purple figures in the gaps in Figure 2). Though there were certainly other factors affecting markets at the time (most notably the eurozone debt crisis), the end of QE 1 was followed by a 13% drop in the markets and QE 2 by a 14%. Consequently, a correction ahead due to the end of QE 3 is to be expected. These declines need to put in context of the market’s previous gains, however. At the end of the post-QE 2 drop, the S&P 500 had still gained nearly 70% from the March 2009 low and today it is up more than twice that. The MSCI ACWI has nearly doubled since March 2009 (price return only). As we have previously noted, there are enough other factors supporting equity markets (earnings growth, valuations, investor sentiment, liquidity), to believe that any retrenchment will be followed by renewed (albeit slower) price appreciation.

Figure 2: QE, equity index returns, and Treasury yields


Last data 7 June 2013. Values at top of chart show trough-to-peak or peak-to-trough price return for S&P 500. Source: BLS, US Federal Reserve, J.P. Morgan Asset Management.

Equity markets, of course, have not been the only victims of recent QE uncertainty. The long-predicted and feared bond market reset may have begun. Returns for every major sector of the bond market are negative from the end of April (see Figure 3).

Figure 3: Fixed income index total returns since 30 April 2013


Last data 7 June 2013. *Total return in local currency/hedged terms.

Source: Barclays, Bloomberg, J.P. Morgan Asset Management.

A slowdown (or anticipation of a slowdown) in QE does not necessarily mean that yields have to rise significantly, however. This is because QE is not the only factor that has driven them so low. Besides the positive impact on equities from QE liquidity, Figure 2 also shows that the relationship between QE and US Treasury yields is not so straight forward. During the first two rounds, yields largely rose despite the increased demand for Treasuries from the Fed, and yields were already quite low when QE 3 began and have generally remained so.

The reason for the poor relationship is that other drivers of fixed income yields have played a more important role than QE, and most of these factors argue for higher yields ahead, regardless of what happens with the Fed. Sentiment about Europe (or at least the euro) is clearly much better today than it was during the worst of the eurozone crisis. The negativity that drove demand for safe haven assets was partly replaced by worries about the fiscal cliff and sequestration in the US, but these are also fading.

If attitudes towards risk are improving, the outlook for growth is more mixed. Economists expect GDP growth to recover from 2.0% in 2013 to 2.7% by next year in the US, so real yields should rise. The UK and eurozone will also see stronger growth but as it is forecasted to be just 1.5% in the UK and 0.7% for the eurozone, the pressure for higher yields will not be as strong.

Fortunately, inflation expectations remain well anchored thanks to investors’ belief that central bankers will tighten if inflationary pressures begin to rise (see Figure 4). This seems unlikely in the short term as unemployment remains high. Credit growth bears watching, however, as the excess liquidity in the US could yet translate into sufficiently strong demand such that prices are pushed up. Currently, growth in bank lending to corporates is running at an above average rate (in real terms) but it is slowing, while consumer borrowing is declining for revolving credit (such as credit cards), and is moderate for mortgages and the like.

Figure 4: Inflation expectations


Last data 7 June 2013. Source: Barclays, Bloomberg, J.P. Morgan Asset Management.

11 thoughts on “Long predicted bond market reset may have begun – J.P. Morgan Asset Management”

  1. Anonymous says:

    If inflation made citizens richer, the citizens of Argentina and Venezuala would be among the wealthiest on the planet …..

    1. Anonymous says:

      Hi ExpatInBG

      The conventional reply is to say that inflation is usually good for reducing the real value of government debt. However with there being a possibility/probabilty of another default from Argentina on Wednesday that theory has had better weeks….

      1. Anonymous says:

        When I was learning about bond yields, the book suggested that inflation would push the bond prices lower -> as investors priced in inflation to achieve the same real return.

        Problem now is that the bond sellers (governments) are using QE to prevent that market correction. Besides being illegal, it is risky – it may produce a black swan event that makes Black Monday look like a storm in a teacup ….

  2. dutch says:

    It’s laughable that in order to generate inflation,Abe has had to increase taxation.How long will that work for?

    On broader front,how can anygovt justify buying 70% of issuance.Kyle bass will eventually be right about japan

    1. Anonymous says:

      Hi Dutch

      As it happens one of the major generators of inflation in the credit crunch era has been rises in indirect taxation. We had the VAT rise to 20% in the UK and many other European countries took that route too as they applied austerity. Now Japan has joined the club and to answer your question only for a year until the rise drops out of the annual comparison. There is one nuance in that there may well be a rise in the consumption tax in Japan to 10% next year so much of the effect may carry on for an extra year.

      If we move to your second question I rather suspect that in time you will be asking why they are buying 100% of the JGB issuance as I think that they are in a trap. It is achieving very little in return for the money being poured into the system.

      1. Noo 2 Economics says:

        “It is achieving very little in return for the money being poured into the system.”

        Yes, I think that’s because Japanese banks are selling JGB’s faster than the BOJ is buying them, hence no increase in money supply. Little growth can happen, which is exacerbated by Japanese companies loathe to give pay rises as this will hit their bottom line, adversely affecting their P/E ratio followed by a fall in share price.

        Current share valuations are based on optimistic earnings forecasts, which in turn are based on optimistic forecasts for the economy which Abenomics is not achieving because of stagnant money supply and wages and so the circle is complete…

  3. Forbin says:

    Hello Shaun,

    I have to admit I’m puzzled , how does printing money and then buying government bonds make people richer ?

    More government debt ? they need more? So the last lot didn’t work so why will it work this time ? or perhaps it did but we’re not in on it?

    Seems that the Gerry Mandered inflation figures are not showing this expansion – but isn’t that the plan?

    And why is it every major 1st world power want inflation in goods and services for its citizens but not in wages ?

    Like I asked yesterday have the top 1% had any suffering at all since the Great Economic crash of 2008 ?

    I can think of some answers none of them pretty though…..


    PS: can I afford popcorn in 10 years time ? the writing’s on the wall for that

    1. Anonymous says:

      Hi Forbin

      I would not be too worried if I was you as most of the advocates of QE have been left confused by how it has turned out. Various theories have been redacted over time as it has not turned out as they expected and hoped. But as you say it has rather benefited the top 1%.

      As to the falls in real wages in the 1st world they seem pretty much ironed into the system don’t they? We need a substantial burst of innovation to escape it….

  4. Anonymous says:

    Great column, Shaun, as usual. Depressingly, the house price
    changes seem to be pushing Japan into deflation rather than the opposite:


    In March the residential property price index was up over the same month last year by -1.3% (-0.1%), the land and detached house price index by -3.2% (-2.4%) and condos by 8.2% (9.7%). The February estimates are in
    brackets. Unfortunately these estimates aren’t the most timely; May estimates won’t be available until July 30.

    Do you think the big increase in VAT in April was a mistake? Would Abenomics have worked better without it? Andrew Baldwin

  5. Anonymous says:

    Idiocy ? or plain simple corruption and nepotism ?

    Given how the BOE & ECB policies favour underwater banks, the latter seems more believable.

  6. Drf says:

    That of course is true, but in the end it is idiocy for the country they are supposed to be governing and managing and its economy. Corruption and nepotism benefit a few indivduals in the short term, but gradually when implemented successively destroy economies, as we can see all too clearly.

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