TOM RICHARDSON: Bond market freaking out over inflation, indications of deep economic pain ahead amid Gulf war
TOM RICHARDSON: Share market investors may be too complacent about a crash. Sinking bonds and other indicators point to deep economic pain ahead.
Multiple asset classes are flashing red as the Middle East war spirals into a deeper energy, inflation and supply chain crisis than investors expected just a few weeks ago.
The sprawling shock from the attack on Iran that spiralled into Gulf War III has already translated into rocketing yields on government bonds. Investors are demanding more compensation for the risk of runaway inflation.
In Australia for example, inflation is tipped to reach up to 5 per cent this year. The government’s interest costs have just hit their highest level in 15 years.
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By continuing you agree to our Terms and Privacy Policy.The soaring interest bill to service sovereign debt also means bond markets won’t tolerate a coronavirus-style blank cheque approach from governments to spend their way out of economic pain.
Prices for industrial and precious metals prices have also collapsed since the Iran war began. Copper known as, Dr Copper, for its ability to predict recessions, has slumped 13 per cent. The broader S&P/ASX 200 Materials Index has crashed 23 per cent since March 2 on concerns stagnating economic activity will hurt demand for commodities.
Shares the last domino to fall
After bonds and commodities, shares tend to be the last domino among asset classes to fall in a serious downturn. So far, they’ve yet to really sink. The broader S&P/ASX 200 marked a 10 per cent fall on Monday, as the conflict heads into its fourth week. Wall Street’s flagship index the S&P/500 is down just 5.4 per cent.
“Given the seriousness of the events in the Middle East, it’s perhaps surprising equity markets haven’t fallen harder in recent weeks – likely because investors hoped Trump would end hostilities at any given moment,” said David Bassanese the chief economist at Betashares.
In his book the General Theory Of Employment, Interest And Money, economist John Maynard Keynes argued assets such as shares can stay elevated for longer than is rational because of the human propensity for “animal spirits”.
This is the philosophical idea of Buridan’s Donkey. The animal is offered two identical bales of hay to eat, but cannot decide which one, so starves to death as it has no “animal spirits”.
The animal spirits in share markets leads investors to overconfidence versus professional bond market traders. In this instance, share market investors are ignoring the coming inflation and interest rate shock as they expect a TACO (Trump Always Chickens Out) related ceasefire from US President Trump.
Mr Bassanese says the odds are worsening for investors to escape this shock given the widespread consequences of the Middle East conflict have already run beyond the US president’s control.
“It’s a Middle East form of MAD — mutually assured destruction,” he said of the growing chaos. “There’s a real risk of a major surge in risk-off sentiment, as hopes for a Trump TACO moment seemingly fade.
“The week ended with Trump issuing an ultimatum that the US would attack Iran’s electricity infrastructure if it did not fully open the Strait of Hormuz within 48 hours. Iran responded by warning it would attack energy and water infrastructure across the region if the US did so.”
Bond markets flash red for inflation
There’s other good reasons to think Australian shares have further to fall. In Australia, the yield on 1-year government debt jumped from 4.14 per cent on February 27 to 4.78 per cent on March 23 , its highest level since May 2011 when the cash rate sat at 4.75 per cent at the tail end of the financial crisis.
Interest rate swap traders are now pricing a cash rate of 4.85 per cent in Australia this year.
In other words, powerful fixed-income markets are betting heavily on a cash rate of 4.75 per cent or more, equal to three more rate hikes. It is hard to see how interest rate settings at their tightest since 2011 will not produce a sharp slowdown in Australia.
Moreover, if longer-dated 10 year bond yields are a proxy for the inflation outlook in any particular country, Australia is facing one of the worst inflation shocks among developed countries.
The yield on Australian government 10-year debt has soared from 4.64 per cent on February 27 to 5.14 per cent on Monday and is now higher than the US at 4.40 per cent, and UK at 4.88 per cent in another signal of tough times ahead.
