The Global Bond Market Could Collapse If the FED Becomes Too Aggressive in Raising Interest Rates

In a scenario reminiscent of the credit crisis, the global bond market could collapse if the Federal Reserve becomes too aggressive in raising interest rates, warns Saxo Bank. Although this does not pose a high risk of global disruption, investors must not overlook potential warning signs.

– The interest rate hikes by the U.S. central bank, the Federal Reserve, will play a crucial role. The Fed’s chair, Janet Yellen, will base rate policy on economic indicators, and this ‘laissez-faire’ approach presents a murky picture that investors need to interpret. If the increase is more aggressive than expected, it could lead to a significant sell-off of corporate bonds as investors seek higher yields – says Simon Fasdal, head of fixed income markets at Saxo Bank.
Another dangerous factor is the extremely low liquidity in the bond market, which could lead to a repeat of 2008 when the credit market collapsed before the financial crisis.

– Liquidity has been at its lowest levels for a long time due to imposed stricter regulations on banks and financial institutions. Many investors have reduced their trading volumes in bonds, such as Credit Suisse, which has withdrawn from its position as a leading dealer in the European bond market – highlights Fasdal, explaining that the ‘air cushion’ is being lost as financial institutions reduce their balance sheets and trading volumes in bonds. Indeed, if a disruption occurs after the U.S. rate hikes, the price drop will be sharper than usual because there simply are no buyers in the market.
Illiquidity remains a constant challenge for the bond market, which has grown significantly in recent years. The bond market in the U.S. is among the largest in the world, having grown from $24 trillion in 2014 to $39.5 trillion, according to mid-2015 data.

– Exceptionally low interest rates have led to an explosive increase in corporate bond issuance. Buyers are mostly hedge funds and mutual funds, so ownership of bonds is more concentrated than ever before. It could be said that the current market is too symmetrical and therefore somewhat vulnerable and fragile – says Fasdal from the Danish investment bank, advising investors to be cautious in trading ETFs and other financial products, especially if the assets are based on high-yield bonds, as any market disruption could also lead to fund closures, as recently happened with Third Avenue Management.