How Bad Will the “Bond Massacre” Get?
The backdrop: after 36 years of bond bull market, the amount of US bonds has ballooned to $47 trillion, up 24% from just ten years ago. The next bond bear market will be bad.
Paul Schmelzing, a visiting scholar at the Bank of England and an academic at Harvard, published an unpleasant scenario on the Bank of England’s blog.
He classifies bond bear markets into three types: the inflation reversal of 1967-1971; the sharp reversal or “Bond Massacre” of 1994; the steepening yield curve or “value-at-risk shock” in Japan in 2003.
He explains that “historically, inflation acceleration has been a solid predictor of sharp bond selloffs.” But other “prominent episodes appear less correlated with fundamentals, and can inflict similar levels of losses.”
There are gloomy ingredients for the perfect storm: the potential for a painful steepening of bond curves, after a sustained flattening as in 2003, coupled with monetary tightening; and a multi-year period of sustained losses due to a structural return of inflation as in 1967.
Schmelzing believes things will likely turn into a toxic combination of Type-1 and Type-2 bear markets.