Albert Edwards, global investment strategist at Societe Generale, said rate hikes by the Federal Reserve may trigger a bond-market “bloodbath” reminiscent of 1994, when California’s Orange County went bankrupt.
Higher interest rates may have unintended consequences, especially since corporate debt levels are at record highs and China is relying on heavy borrowing to maintain economic growth, he said.
“The U.S. Fed has created another massive credit bubble that will, when it bursts, lay the global economy very low indeed,” Edwards said in a March 9 report obtained by Newsmax Finance. “Accelerated Fed rate hikes will cause tremors in the Treasury bond markets, forcing rates up.”
Investors expect the Federal Reserve to raise interest rates by 0.25 percentage point to an eight-year high of 1 percent at its meeting next week. It will be the third increase in the past 11 years.
Edwards compares today’s market to 1994’s, when the Fed had indicated its intention to raise rates but the bond market was still unprepared.
“Despite the Fed’s telegraphing the series of rate hikes and market participants forecasting multiple hikes, it was most curious how the market went into total convulsion,” Edwards said. “It was a bloodbath.” Two-year Treasury notes were hit especially hard.
Orange County, a suburban area south of Los Angeles, was the highest-profile victim of the bond-market carnage. The local government filed for the biggest public bankruptcy in history after suffering a $1.64 billion loss on structured notes whose value declined as interest rates rose.
Prior to the loss, the county had $7.6 billion of its own capital to invest and then borrowed another $12.5 billion from Wall Street brokers in an attempt to boost its returns, according to Fortune magazine.
As bonds fell in value, lenders asked for more collateral that the county didn’t have. In what amounted to a massive margin call, some brokers sold the collateral and the whole investment scheme swooned into a death spiral.
“Accelerated Fed rate hikes will cause tremors in the Treasury bond markets, forcing rates up, most especially in the 2-year – just like 1994,” Edwards said.
If history repeats, the 2-year Treasury note will sell off and pressure yields throughout the global bond market.
“We could easily see 2-year yields rise towards the 10-year as we did in 1994,” Edwards said. “If that happens and the U.S. 2-year spread with German and Japan continues to soar, this will be like rocket fuel strengthening the U.S. dollar.”
A stronger dollar will hurt the profitability of U.S. companies that sell products in other countries. Profits will look smaller when converted from foreign currencies into dollars, while U.S. goods will become more expensive to overseas buyers.
“We are in for a rough ride, especially with equity markets at record highs,” Edwards said. The S&P 500 has risen 19 percent in the past 12 months and last week hit a record intra-day high of 2,400.98.
Edwards has been on the record with bearish calls since introducing his “Ice Age” thesis in 1996. The forecast advised investors to put money into bonds and be cautious with stocks as deflationary pressures like those seen in Japan spread throughout the world.
Japan has struggled with repeated recessions and slim growth since its economic bubble collapsed in the 1990s.
Bond Market BTD
Edwards recommends buying bonds amid the bloodbath, because he anticipates the Fed will have to respond to economic weakness by cutting rates and buying U.S. Treasury debt to flood markets with dollars.
Under Chair Ben Bernanke, the Fed oversaw several billion-dollar bond-buying programs to help drive interest rates to record lows. Central banks in Asia and Europe are still buying financial assets in an attempt to stimulate growth.
“As yet another central bank-inspired global recession unfolds, I believe U.S. 10-year bond yields will ultimately converge with Japanese and European yields well below zero,” Edwards said. “In other words, buy 10-year bonds on weakness!”
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