The turmoil we are currently seeing in stock and bond markets is just one battle in the war that has been going on in capital markets for a long time: debt versus equity versus central banks.
Debt is the conservative, unadventurous view on a business; bondholders worry more about getting their money back than about the businesses’ ability to innovate and expand.
Equity on the other hand is the real investment, so to speak: shareholders are betting that the company has good enough ideas, business strategy, management, workforce, products, services, etc. to deliver growth in revenues.
Central banks have tried – and so far, have succeeded – to keep these two forces under control.
It is always hard to predict which side will win a round, but this time this is made worse by the fact that debt has been used in the same way as equity by a lot of investors for quite a long time.
In the past, many buyers of bonds would have been happy to just sit on their investment, collect the coupons (regular interest payments) and at the end of the life of the bond, have the principal paid back to them.
Whenever bondholders thought the chances of them getting paid either the interest or the principal were falling, they would ask for a higher rate of interest to compensate for this risk.
However, since the turn of the century at least, bondholders have preferred to play the short-term game. No more patience in the bond market.
This may have to do with the fact that central banks have been intervening in markets more and more, trying to dictate, rather than subtly suggest, the cost of borrowing for almost everything.
First, they kept interest rates artificially lower than economic conditions would have warranted.
This led to bubbles in specific assets. The most obvious one was the real estate bubble that burst in 2007, leading to what is now known as the Great Financial Crisis.
To get out of that one, with interest rates already too low to be slashed further, central banks resorted to what at the time they called “temporary” or “emergency” measures: purchases of assets. In other words, money-printing.
And following the March 2020 selloff as investors feared the outcome of the Covid-19 pandemic, the Federal Reserve temporarily lifted the requirement that large banks must hold capital reserves for the Treasury bonds they own.
Bondholders got the message. More and more of them placed bets on bonds the same way equity investors would: they bought and sold looking for capital appreciation, rather than income.
This works when interest rates keep falling — and they have been falling for such a long time that many market participants have forgotten or have never experienced them going up.
It is what central banks want, actually: they want investors to take risks, go out there and spend, which is why they have taken all these “unorthodox” measures. They want investors to believe in their power.
But a big question mark has been handing over this whole process from the beginning: what happens if investors lose faith in central banks?
Many believe this to be impossible. After all, the central bank is the big gorilla in the market: you either do what it wants you to do, or get out of the way.
But investors keep testing central banks’ credibility. It happened in 2013 with the now-famous “taper tantrum” and it happened in 2015, when there was another bond and equity selloff, in which central banks again seemed to lose their grip on markets.
This time it may be even more difficult to predict who will win this battle. The Covid-19 pandemic has changed the world in so many ways, that we are only just beginning to figure out what the new normal will look like.
Central banks, as much as investors, have to find a way to price this in. An important test will be whether the Fed decides to extend the suspension of the capital requirements for big banks.
If the Fed does extend it, then markets could stage a relief rally. But if it does not, the market reaction will be an important signal on whether investors think the economic outlook is robust enough.