The fashionable talk in financial markets these days is of a ‘Great Rotation’ from bonds into equities, a smooth transition from the largest bond market bubble in history to a more normal balance between equities and bonds.
It is certainly far from usual to have bonds yielding two per cent and equities twice that amount in many cases. That makes it look attractive to shift from the so-called safe haven of bonds back into the supposedly more risky world of equities.
Look at the move out of bond funds and back into equities and there is certainly evidence that this is happening. The problem comes when the bond market finally blows up. Financial markets do not have a propensity to deflate gradually. The normal thing is for investors to all suddenly lose confidence together and rush for the exit door.
Now in bond market terms that means a sudden upswing in interest rates around the world. Remember bond yields or interest rates move in the reverse direction of bond prices. What impact does a sudden surge in borrowing costs have on equities? The initial reaction just has to be very negative.
Higher interest rates are a cost increase for business and customers alike. It’s a major depressant to the economy as nasty as a big tax hike. It means the end of the Fed’s zero interest rate policy. Hedge funds can no longer borrow cheaply to invest in shares paying dividends higher than bond yields.
Indeed share prices have to come down so that their own yields can go up to compete with bonds. The dividends presently paid on stocks only seem a good return in comparison with bond yields which are at record historic lows. Dividend yields go up when share prices come down.
Where does this leave precious metals as an asset class? Well if money is coming out of bonds and at least temporarily equities in a global financial reset then where does it go? Cash is certainly one place but which currency could you trust? Gold and silver are monetary metals and the oldest currencies of all.
Now both gold and silver are supply-constrained markets. That is why they are often favored over paper money in times of crisis, and a bond market bust certainly will rank as a major global financial crisis.
In fact, gold and silver would become to some extent the only game in town for a while and turn into the ‘ultimate bubble’, as George Soros once put it, before a real ‘Great Rotation’ back into other assets as governments moved to reset the global monetary system, almost inevitably including precious metals as the only thing with value trusted by everybody.
That is why gold and silver would boom in a bond market crash, not equities although there would be a steep recovery from the initial stock market sell-off and a once-in-a-generation chance to buy at low share prices. But share prices would still be lower than they are today because stocks would have to pay higher dividends.
Posted on 29 January 2013 – ArabianMoney