What Fidget Spinner Mania Can Teach Bond Traders
We are panicking over interest rates. Estimates of how high the Federal Reserve will raise its main rate to get inflation under control seem to increase daily. The yield on the benchmark 10-year U.S. Treasury note has surged 1.25 percentage points this year, inflicting historic losses on bondholders. Mortgage rates are now above 5%, increasing from less than 3% as recently as September and prompting predictions of imminent carnage in the housing market.
It is in times like these that I pay particular attention to sentiment, which it is expressing maximum fear about interest rates. That is good news for the bond market and anyone who is worrying about the rapidly rising cost of money, but not so much for the economy.
The first thing to know is that every time there is a rapid increase in rates, something “breaks” in the economy, causing a lot of stress and slowing growth. In 1994, it was the bankruptcy of Orange County, California, and companies, most notably Procter & Gamble Co., lost big by betting the wrong way on interest-rate swaps. That was a horrible year for the bond market, but the fallout led to a great year for bonds in 1995. And don’t forget about 1987, when 2-year Treasury yields soared through the first three quarters of the year, culminating in the epic crash in stocks that October. Again, most of 1987 was horrible for bonds, but the market rebounded in the fourth quarter and generated big gains in 1988.
The lessons from those and other episodes is that it is not so much the absolute more in rates that is a problem, but the speed. Markets need time to adjust. And while it’s always hard to predict what might “break” as a result, you always have to keep an eye on the derivatives market. The International Swaps and Derivatives Association predicted in December that the notional amount of interest-rate swaps totaled $372.4 trillion, although it’s not the notional amount that matters, but the next exposure, which is hard to measure.