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Global bond markets have been through a meat grinder over the past few weeks, causing pain for everyone from retail investors to insurance companies.
Worryingly, the cause is unclear. But here’s how the competing schools of thought work: Theory one is that the investment world’s so-called big brains were caught off guard by the rise in global interest rates and are scrambling to catch up. Central banks are consolidating their view that interest rates will remain higher for longer, and slow-moving investors have long been wrong. Something has to give, and it all balances out quickly.
Theory two is that we are in a catastrophic reckoning with the fiscal incontinence and reliance on low interest rates that have emerged over the past few decades, and we should be prepared for serious challenges to the dollar and the U.S. government’s global dominance. Bonds are in centrality of financial markets. This isn’t going to end anytime soon.
This fundamental rethink has already occurred due to the scale of the market turmoil. Government bond prices have been under pressure all year as interest rates have continued to rise, but there have been some recent hiccups. Earlier this week, benchmark 10-year and 30-year U.S. Treasury yields surged to their highest levels since 2007, amid some intraday volatility.
“If Tuesday was market chaos, Wednesday was chaos on a drug bouncer,” Rabobank’s Michael Every wrote. “This is First among equals Everyone around the world must be concerned about borrowing costs in the global bond market, and it trades like penny stocks. ”
Friday’s hot U.S. jobs report added fuel to the fire, sending 10-year Treasury yields around 4.8% and 30-year Treasury yields above 5% — well above even the most reasonable forecasts.
The combination of sickening volatility, falling bond valuations and sky-high benchmark borrowing costs is raising concerns about corporate defaults and unstable sectors such as regional banks and commercial real estate.
Under normal circumstances (remember those?), when stocks rise, bond prices fall, creating a good balance. Now, though, stocks are also under pressure as investors believe fund managers would rather buy bonds at low prices that are unlikely to default than bet on stocks, where smaller companies may struggle to repay debt.
Matthew McLennan, co-head of global value at First Eagle Investments, is among those concerned about the deepening shakeout in bonds. He said that although the Federal Reserve implemented punitive interest rates this year, “fiscal easing” has kept the market afloat and protected the U.S. economy from damage. It’s getting harder and harder to see who will foot the bill.
The danger from here is that either we get high interest rates, or there is a sudden reduction in government spending, leading to a recession that does not affect market prices. Or, he said, “we got Liz Truss,” with a huge lending target, expensive interest rates and a shrinking pool of potential buyers. “The situation is serious . . . given that the dollar is the reserve currency,” he said. “The Fed is going dynamite fishing. We’ve seen some fish (come to the surface) like cryptocurrencies, but we haven’t seen the big whale yet.”
Fiscal deficits are suddenly a topic again. Grand theories abound as to how huge holders of official reserves such as China or Japan could begin selling off Treasuries, or at least launching a buyer’s strike. That would certainly be disastrous. But for decades, this risk has been a non-biting dog, and this thinking ignores the fact that the global system is based on the U.S. dollar, and Treasuries remain the world’s premier safe-haven asset. Evidence for a large-scale withdrawal from U.S. dollar reserves is scant at best.
The truth may be more prosaic. Yes, the increase in U.S. borrowing targets did cause some indigestion. Investors are demanding higher returns to get a piece of the pie, and governments will feel the impact of rising debt-servicing costs for many years to come. But this does not mean the beginning of the crisis.
“When people see big moves, they look for elegant and interesting reasons,” said one senior bond trader. “The reality is it’s hard to accept that everyone’s getting better.” In other words, large investors had been betting aggressively on bonds, in part in anticipation of rate cuts, but eventually capitulated. As the end of the year approaches, 2023 returns tend to look lackluster and funds are cutting losses, he said.
Overall, the message is finally being accepted, as interest rates remain high for an extended period of time and will likely continue to move higher. Fed Chairman Jay Powell emphasized this at the Jackson Hole symposium in August: central banks are not planning to change course. “The Fed has been very successful in communicating this,” said Ed Cole, managing director of discretionary investing at Man GLG. “Collateral damage is the rate-sensitive part of the market.”
Bond repricing is painful for all debt holders currently facing paper losses and humiliating for those who confidently, repeatedly, and incorrectly declared the highest yields. No one really knows how high yields can be obtained from here, but the hope is that this won’t get out of hand, but will become a self-correcting mechanism: the more impact market rates have on corporate and government finances, the sooner central banks will blink. .
katie.martin@ft.com
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