The bond markets are seeing a sell-off. Yields on 10-year U.S. Treasuries rose as high as 2.90% in mid-February, compared to the September 2017 low of 2.04%.
And with the recent spike in volatility, some investors are reminded of the precursors to the 2008 financial crisis, when bond markets were jittery before other markets followed suit. So what is happening, and should international equity investors be concerned?
In January, Ray Dalio (founder of Bridgewater Associates) commented that he believes the Federal Reserve will tighten monetary policy faster than the market expects, which will put pressure on all asset prices. The yield curve has also flattened considerably over the past few years; the spread between 2-year and 10-year U.S. Treasury bonds has declined from 260 bps in the beginning of 2014 to 67 bps in mid-February 2018. This restricts lending, which in turn, will hamper the economy. Furthermore, Dalio says that because the economy is more sensitive to rates due to the longer duration of assets, even a 1% increase in bond yields will create the largest bear market in bonds in almost 40 years.
What does this mean for stocks and for international equity investors? Perhaps, this is the negative catalyst that bears have long been waiting for. Until recently, stocks have been relentlessly buoyant in the face of negative news, perplexing investors focused on company fundamentals and valuations. We also find it interesting that in the run up to the Italian elections (scheduled for March 4, 2018), Bridgewater has amassed a large short position against European stocks. The firm's most recent company filings show Bridgewater is short Europe by around $22 billion, compared to the fund's total $150 billion in assets. As a reminder, we wrote a note in December 2017 of the lofty valuations of the European bank stocks, and that the remaining upside in the stocks may not be attractive relative to the potential downside. When considering the potential negative catalysts of rising interest rates, stretched valuations and looming political risk in Italy, the probability of a drawdown in the international equity markets is increasing.