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Global bond markets have been through a mincing machine in the past few weeks, inflicting pain on everyone from retail investors to insurance companies.
Alarmingly, it is not obvious why. But the competing schools of thought work something like this: theory one is that the supposedly big brains of the investment world have been spectacularly wrongfooted by the ascent in global interest rates and are scrambling to catch up. Central banks are cementing their view that rates will be higher for longer, while slower-moving investors have been wronger for longer. Something had to give, and this will all balance out and blow over soon.
Theory two is that we are at the foothills of a catastrophic reckoning with the fiscal incontinence and addiction to low rates that had taken hold over the previous few decades, and we should brace for a serious challenge to the global dominance of the dollar and US government bonds’ centrality in financial markets. This will not blow over soon.
That kind of fundamental rethink has taken hold because of the scale of the market ructions. Government bond prices have been under pressure all year as rates have cranked higher, but recently something snapped. At the start of this week, yields on benchmark 10- and 30-year US government bonds vaulted to the highest levels since 2007, with some volatile intraday shifts.
“If Tuesday was market chaos, Wednesday was chaos on a trampoline on drugs,” wrote Rabobank’s Michael Every. “This is the primus inter pares of global bond markets which everyone everywhere in the world has to look to for the cost of borrowing, and it’s trading like a penny stock.”
Friday’s hot US jobs report added fuel to the fire, leaving 10-year yields around 4.8 per cent and 30-years over 5 per cent — far above most sensible forecasts.
The combination of nauseating volatility, sinking bond valuations and sky-high benchmark borrowing costs is stirring concerns over corporate defaults and shaky sectors such as US regional banks and commercial real estate.
In normal times (remember those?), bond prices dropped when stocks were climbing, creating a nice balance. Now, though, stocks have also been under pressure as investors calculate that fund managers would rather buy bonds that are unlikely to default on the cheap than take a punt on equities, and that smaller companies might struggle to pay debts.
Matthew McLennan, co-head of global value at First Eagle Investments, is among those nervous that the bonds shake-out runs deep. “Fiscal laxity” has kept markets afloat and shielded the US economy from harm despite the Federal Reserve’s punishing interest rates this year, he says. Now it is getting harder to see who will foot the bill.
From here, the danger is that either we get high rates and a sudden pullback in government spending, producing a recession that is not baked in to market prices. Or, he says, “we get Liz Truss”, with outsized borrowing targets at expensive rates and a dwindling pool of potential buyers. “It’s a serious situation . . . given the dollar is a reserve currency,” he says. “The Fed is dynamite fishing. We have seen a few fish like crypto [float to the surface] but we have not seen the big whale yet.”
Fiscal deficits are suddenly a talking point again. Grand theories abound on how huge official reserve holders such as China or Japan could start selling, or at least stage a buyers’ strike on Treasuries. That would certainly be cataclysmic. But this risk has been the dog that does not bite for decades, and the idea overlooks the fact that the global system runs on dollars, and Treasuries remain the world’s premier haven asset. The evidence of a wholesale shift out of dollar reserves is scant at best.
The truth is probably much more prosaic. Yes, there’s some indigestion from higher US borrowing targets. Investors are demanding higher returns to take a slice of the pie, and governments will feel the impact of higher debt servicing costs for many years to come. But that does not add up to the start of a crisis.
“When people see big moves, they look for elegant and interesting reasons,” says one senior bond trader. “The reality is it’s difficult to accept that everybody was long.” In other words, big investors have been running positive bets on bonds, partly in anticipation of rate cuts, and are finally capitulating. With the end of the year approaching, and returns for 2023 often looking drab, funds are cutting their losses, he says.
Broadly, the message is at last sinking in that rates are staying high for a good while yet, and may go higher still. Central banks do not intend to reverse course — a point Fed chair Jay Powell hammered home at August’s Jackson Hole symposium. “The Fed has done a very successful job of communicating that,” says Ed Cole, managing director of discretionary investments at Man GLG. “The collateral damage was the rate-sensitive parts of the market.”
The repricing on bonds has been painful for all the debt holders now sitting on paper losses, and humbling for those who have confidently, repeatedly and erroneously declared a top in yields. No one truly knows how high yields can get from here but the hope is that rather than running out of control, this will prove a self-correcting mechanism: the harder market rates bite in to corporate and government finances, the sooner central banks will blink.