Should U.S. Treasury yields jump 3 percentage points, the losses to investors could hit $1-trillion (U.S.).Matthias Haas/Getty Images/iStockphoto
Try all they want, even the most sophisticated investors probably can't flee the bond market unscathed.
That's the word from the venerable Bank for International Settlements, which notes in its latest annual report that "there may be limits to investors' ability to hedge effectively if the transition to higher rates turns out to be particularly abrupt and bumpy."
Should U.S. Treasury yields jump 3 percentage points, the losses would hit $1-trillion (U.S.). the BIS calculated. Assuming the hikes trickled through the developed world, losses on debt issued by France, Italy, Japan and the United Kingdom would also range from about 15 per cent to 35 per cent of each country's gross domestic product.
Sound too far fetched? Maybe. But keep in mind that Treasury yields have already jumped 70 basis points in under two months. And there's a recent precedent for a prolonged rise.
"Yields are not likely to jump by 300 basis points overnight; but the experience from 1994, when long-term bond yields in a number of advanced economies rose by around 200 basis points in the course of a year, shows that a big upward move can happen relatively fast," the BIS noted.
The hurt could be widespread. "In this situation, counterparty risks are also likely to emerge, as aggregate exposures to interest rate risk cannot be eliminated by such private sector practices," the BIS added. "And, with banks holding significant portfolios of long-dated fixed income assets, a sharp rise in interest rates could also raise the risk of financial system stress."
However, there is some good news. Not too long ago, there were worries that it would be nearly impossible for central banks to raise interest rates before they wound down their bond buying programs. Not so anymore. "Central bank deposit facilities, payment of interest on excess reserves, term repos and other arrangements now offer central banks a wide range of options that allow them to decouple policy rate from balance sheet policy decisions," the BIS noted.
Should the current market calm once investors come to grips with their morphine drip – better known as bond buying – running out, the BIS hopes the Federal Reserve stays committed to a hands-off recovery. "Monetary stimulus alone cannot provide the answer because the roots of the problem are not monetary. Hence, central banks must manage a return to their stabilization role, allowing others to do the hard but essential work of adjustment."