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Bond Market Bloodbath: What Caused Last Week's Global Market Selloff?

Mar 3, 2021 9:44 AM 5 min read

What’s eating global stock markets?

Last week was a veritable bloodbath for financial markets across economies. Equity, bond and commodity markets suffered a dramatic sell-off even as the prices of oil and gold nosedived.

In India, foreign portfolio investors (FPIs) dumped Indian equities worth ₹8,300cr ($1.1bn), triggering the biggest single-day fall in the Rupee in nearly 19 months. Indices dived down too, additionally hurt by a surge in COVID-19 cases and rising oil prices.

For those following the news, the market slump may have come as a surprise. After all, there’s been some light on the horizon of late. The pandemic is ebbing as the global vaccination drive picks up steam, economies are slowly emerging from recession - including India, which on Friday posted 0.4% Q3 growth after two consecutive quarters of contraction, and the US House of Representatives recently passed a massive $1.9trn coronavirus stimulus package.

Why the volatility, then? The answer lies in this chart:

Bond Market Bloodbath: What Caused Last Week's Global Market Selloff?
Source: FT

This represents the yield on the 10-year US Treasury bond, which recently rose to as much as 1.61%. On Thursday, it closed at 1.513% - its highest closing level in a year. And it has been steadily rising for some weeks now, climbing 0.369 percentage points in February - its largest one-month increase since November 2016.


Vision 2020

For most of last year, US bond yields were at historically low levels, kept there by a pandemic-struck economy and a dovish Federal Reserve that promised to keep interest rates at near-zero levels for possibly years to come.

Now, low yields = virtually no returns on bonds = investors look to other avenues for investments. These include equities. And thus in 2020 there was a flight of capital to the stock markets, contributing to bullish rallies and ballooning market caps (particularly of tech stocks) even as the larger economic landscape remained grim.

Increased government spending and central bank interventions to support the economy kept the party going. In August, the Fed said rates would remain low even if it meant an uptick in inflation. For equities, these developments meant easy money. For businesses, they meant easier access to credit. And for emerging economies such as India, they meant more foreign capital inflows and a well-performing currency.


Reality 2021

In 2021, the outlook shifted. Investors feared that a broad economic recovery could (1) spur inflation and (2) prompt central banks and governments to withdraw monetary and fiscal support earlier than expected. This drove bond yields higher, which in the long run could mean higher borrowing costs for businesses. It also sparked a reverse flight of capital from riskier assets such as corporate bonds and big tech equities (Apple, Tesla, Amazon, Facebook etc.), the biggest beneficiaries of a broader low yield environment.

Moreover, it’s not so much that US bond yields spiked - considering their record low 2020 levels, some correction was anyway in the offing - but how quickly they did. For context, the 10-year yield ended 2020 well under 1%. Last Thursday it crossed 1.6%. So it has jumped by over half a percentage point in less than two months!

Some central banks stepped in to placate investor fears immediately - Australia’s has doubled its purchase of long-term bonds. And senior Fed officials underlined their commitment to continue supporting the economy through the pandemic. Sensex and Nifty ended Monday in positive territory and equities in Europe and Asia-Pacific have risen. US bond yields have cooled off too. But this doesn’t mean we’re out of the woods yet.


All Eyes on America

Are we headed for a period of high inflation? The answer to that question depends on whether or not the Fed will stick to last year’s Jackson Hole promise to not raise interest rates. And to be fair, revisiting inflation-targeting (and QE tapering) sooner rather than later may not be off the table.

The US economy, while still battered by the pandemic, is recovering faster than expected. Last week, data on new unemployment insurance claims, consumer spending and household incomes beat expectations. And an update to Q4 GDP growth estimate came in at a healthy 4.1%. Consumer prices in January were up only 1.4% YoY but recent indicators of retail sales, durable goods purchases and service sector prices have shown inflation might be in the pipeline. The 5-year breakeven rate, an indicator of the bond market’s expectations for inflation, rose to 2.38% last week, its highest level since before the Great Recession.

A swift recovery could lead to an abrupt surge in consumer spending and demand, which is expected as the economy reopens, and robust growth could lead to overheating. This could pull headline inflation upwards beyond the Fed’s 2% level.

Now, Fed Chairman Jerome Powell told Congress last week that he would be content with maintaining the status quo even if the rate climbed to 3%. And to be sure, an uptick in the inflation rate is likely in the near-term as sectors such as hospitality, travel and transportation get back to business. There is bound to be more spending as economies reopen, which would invariably drive prices up.

The trillion-dollar question is whether this spike will be short-lived or grow to unsustainable levels. It’s a tricky slope to tread on. After all, inflation-targeting is a game of pre-empting. No central bank would be willing to wait things out for a long time. Keeping a cat in a bag is easier than getting it back out there!


Tantrums over Tapering

Last week’s market chaos sparked predictions of runaway a second “taper tantrum” or “inflation tantrum”.

Back in 2013, the Fed signalled a scaling back (aka “tapering”) of its programme of buying bonds from the market to inject additional liquidity (aka quantitative easing or QE), something it began doing after the 2008 crisis. This elicited a sharp market response (aka “tantrum”) that saw bond yields nearly double and briefly knocked world shares by 10%.

This time, the culprit may be inflationary forces pushing another taper.


Where Do We Go From Here?

Global indices have begun March 2021 on a relatively stable footing. Things aren’t as volatile as last week. And things are definitely not as volatile as March 2020 - the original “Ides of March”, so to speak.

But what happens next, only time will tell. Perhaps recovery will be manageable enough to avoid excess inflation. Or perhaps things will spiral out of control. (Not to sound alarmist but former US Treasury Secretary Lawrence Summers warned that US inflation could reach its highest point in 40 years, especially with a loose fiscal policy - $1.9trn worth - adding to an already loose monetary policy.)

If nothing, a rise in interest rates could address valuation concerns that have grown louder in recent months over worries that we are in a stock market bubble. We’ve seen how low bond yields have induced a flood of capital towards listed companies, especially the larger and tech ones, whose market caps have skyrocketed. After a roller-coaster 2020, these firms are possibly staring at a sombre year, with more capital pulling out down the road and bringing their market caps back down to earth.

Ray Dalio’s musings around his so-called “bubble indicator” may serve as much-needed food for thought.


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