After the savage, dehumanising revenge killings perpetrated by Hamas on Israeli civilians, a forceful, habitually disproportionate military campaign against the entire Gaza Strip has started. Israel and its Israel Defence Forces is now forced to act ‒ irrespective of all past failures to find a just solution for the grievances of its Arab population.
The fenced-off enclave which is Gaza, already disconnected from water and electricity networks, fuel supplies and humanitarian aid, and without any exit route for its civilian population – will either face obliteration from the skies, extended war operations on the ground, or a combination of both. The best possible outcome, military restraint, is the most unlikely.
Israeli citizens, scared for their lives as never in the last 50 years, would not forgive a dithering political party at the ballot box.
It is a scenario rife for escalation. Hezbollah has already started to test Israel’s border with Lebanon. Iran, a long-term supporter of both Hamas and Hezbollah and habitually in the crosshairs of right-wing Israeli governments, is airing blatant threats. Other Arab nations, none of them a democracy, will wish to be seen by its populace to be supportive of the Palestinian cause. The US, hoping that displaying gunboats are enough a token to show unwavering support, is trying to nudge Israel into moderation; as if Israel had ever listened to its staunchest supporter.
After Ukraine, this is the next conflict to have potentially grave consequences for energy markets. While Iran’s recently growing oil exports, condoned by the US to counter OPEC’s and Russia’s export curbs, will be reined in again, Saudi Arabia and its Gulf allies cannot be seen to give Biden a helping hand with US consumers at the fuel pump either. Yet the oil markets have hardly reacted. Brent is slightly up, as is gold, a safe haven in troubled times.
Not much drama yet. The real threat to investors is the ongoing inflation battle of the Fed. “Higher for longer” interest rates display their ever more oscillating effects on bond and stock markets. Shouts about the likely outcomes of inflation fighting is drowning out the noises of areal bombings.
The common mantra, that we are witnessing the end of a 40-year bull market in bonds, is derived from dramatic facts on the ground. At 4.9%, yields of ten-year US treasuries are at their highest in 16 years. In a little more than a year, short-term interest rates have shot up by more than 5%. In this brief period, US government bonds of all durations combined, have lost 25%. Ten-year paper lost 47%, 30-year obligations 53%. In Europe and elsewhere the picture was similarly dire. It was the biggest market rout in living memory. The brutal increase of the cost of borrowing had everyone predicting a painful recession any time soon.
It did not materialise, at least not in the US (as ever dictating global financial conditions) and not even in European markets other than Germany The postponement of the reckoning has led to widely fluctuating markets. Good news about the economy and the job market triggered repeatedly fears of an imminent recession ‒ engendered by the heightened expectation of an even more aggressive Fed, while weaker data, perversely, gave hope for a “soft landing” ‒ mission accomplished. By now, while expectations of an imminent recession have subsided, the unwinding of an ever-steeper yield-curve inversion had alarm bells going off again.
The longer spectrum of government bonds saw yields rising rapidly, thus narrowing the gap between higher short-term interest rates and lower long-term yields. Instead of the Fed softening its stance, the bond market itself is increasing the long-term cost of borrowing. It is “doing the central bank’s job”, as the saying goes. “The term premium” – the mark-up investors demand to lend over longer periods – is rising. A thing considered normal in the past – higher compensation for locking in savings over a longer time horizon – is read now as something deeply unsettling.
A range of explanations is offered. If interest rates stayed in fact higher for longer, long-term lenders would lose money. Better to park money in high-yielding money market instruments as long as such possibility is not compensated for in longer maturities.
Some observers point to waning demand from central banks like Russia and China to sanction-proof their foreign currency holdings. This is not quite true. Foreign central banks still hold large amounts of US debt. But they see no need to add more to it. As buyers they are static rather than active. Some foreign investors seem deterred by rising hedging costs, like Japan, and a strong dollar. Any reversal of the dollar’s good fortune would impose additional losses on foreign investors.
Retail investors and professionals come to the fore as marginal buyers- Andreas Weitzer
Others point to the overwhelming need of the US government to issue new debt. To cover ever-higher interest payments on their borrowings and the sprawling budget deficit as well as fast-maturing debt, the supply of US government bonds may overwhelm current demand. The recent, troubled auctioning of 30-year bonds is listed as evidence. Even the increasing dysfunctionality of US law-making is stressed, pointing to the political, as opposed to financial, deterioration of its debtor status.
Banks, having lost on their “safe” bond holdings, fear to get burnt again.
In all of the above is some truth, if at the margins. What has changed monumentally is the direction from quantitative easing to quantitative tightening. The Fed and other central banks in the developed world have stopped acting as bond buyers of last resort. While in the past they would have gobbled up debt instruments irrespective of their price they are now shedding their previous investments over time. As a result, retail investors and professionals come to the fore as marginal buyers, reactivating price setting mechanisms long dormant. While some of them, like pension insurers, are comparatively price-insensitive, others will compare stock market returns, weigh recession and inflation risks, or the likely path of interest rates.
I am not a tealeaf reader. The logical scenarios unfolding in the absence of the – unpriced – tail risks of war in the Middle East and elsewhere are the three possibilities of (1) a recession, (2) economic resilience despite all headwinds, and (3) stagflation, where untamed inflation combines with a market downturn.
My personal fear as a retail investor is that we have perhaps seen inflation coming down irreversibly, possibly even within the declared aim of 2% within the next two years, but nothing so far of the full effects of quantitative tightening. A recession seems the most likely scenario to me, or a disruptive, financial-systemic accident.
Consumers, hit by falling real incomes, have started their belt-tightening. Credit card defaults are on the rise, credit card spending, the last hurrah when savings have been eaten up, are falling. Bank credit is harder to come by and more expensive.
Small firms are beginning to struggle. This will accelerate as banks start to feel the cost of rising defaults and hence retreat even further from lending. Big corporations will curb capital spending and research investment. In such scenario, with recessionary effects multiplying, long-dated bonds with good credit-rating will prove a good hedge, no matter how loss-making they look at the moment.
Such fixed-rate obligations will even fare well if a recession can be avoided (2). We will know it is over when the central banks stop hiking. Eventually central banks will be more accommodating. To time a good entry is futile. Better settle for what is on offer now.
Only in case of (3) stagflation will bonds suffer. But so will everything else. To preserve value, only miners, energy companies, and consumer staples can minimise inflationary losses. Great money earners they will not be. Make your choice.