They punish governments that dare to deviate from financial orthodoxy. They strike fear into the hearts of finance ministers. They were seemingly a dying breed in the years between the crash of the late 2000s and the 2020 Covid-19 pandemic, but now the bond market vigilantes are heading back into town.
In the recent past, governments were able to borrow unlimited amounts at extremely low interest rates. For almost three years, investors actually paid the German government to lend them money due to negative bond yields.
The days of low interest rates are behind us. The German government now has to offer a 3% yield to entice buyers for its 10-year bonds. In the US, the interest rate on a 10-year bond briefly exceeded 5% earlier this week, reaching its highest point since 2007. UK government debt with a 30-year term also experienced a spike in yield, reaching levels not seen since the late 1990s.
Atypically, the increase in bond interest rates has occurred during a period of increased global unease. During times of war, investors become anxious and often shift their investments from stocks to the perceived safety of bonds. US treasury bonds are seen as a reliable option, as the US dollar holds the advantageous position of being the world’s reserve currency.
This time, there was a notable change. Although there was a slight decrease following the beginning of the conflict between Israel and Hamas at the beginning of this month, US bond yields promptly returned to their upward pattern.
What is currently occurring? Inflation has reached its highest point and is decreasing in all western regions. Interest rates are at or near their highest point. The global economic forecast is not particularly optimistic. These factors should benefit bond prices, as they typically rise when bond yields decrease and vice versa.
According to Jim Wood-Smith from Hawksmoor Investment Management, we can be fairly certain that we will not face the same inflation issues as last year and that bank interest rates are currently at or close to their highest point. Economic indicators suggest that there may be some challenges ahead as housing and job markets have slowed down and consumer spending has decreased since the holiday season. Additionally, the weather is unfavorable. Despite these factors, bond yields continue to increase, which is unexpected.
Wood-Smith explained that there are two main factors at play. The first is the poor state of government finances in many countries, which becomes increasingly costly as bond yields rise. The second factor is the continued efforts of the Federal Reserve and the Bank of England to sell off large amounts of treasuries and gilts in a process known as quantitative tightening.
Netwealth’s chief economic strategist, Gerard Lyons, noted that the bond markets were significantly impacted by the shift from central banks purchasing bonds to selling them. He argued that central banks were mistaken in their belief that quantitative tightening, or bond selling initiatives, was simply a technical process. According to Lyons, this change means that central banks are no longer guaranteed buyers of bonds, which has implications for the economy and financial markets.
Lyons mentioned additional reasons for the increase in bond yields. These include the belief that interest rates will need to remain elevated for an extended period in order to address underlying inflationary pressures, as well as worry over the size of government budget deficits. The term premium, which compensates investors for the risk of holding long-term debt, has also been on the rise.
Bond market investors are particularly worried about the $1.7 trillion deficit under the Biden administration in the United States. As the largest bond market in the world, any concerns about US fiscal policy have ripple effects on other markets.
The United Kingdom is among the nations impacted by rising expenses for managing government debt. Chancellor Jeremy Hunt has cautioned that interest payments for this year will be £20-30 billion higher than what was predicted in the spring.
Vicky Redwood, the senior economic adviser at the consultancy Capital Economics, said: “The rise in bond yields will obviously push up governments’ debt-interest costs. This comes against a backdrop of [quantitative easing] effectively shortening the average maturity of government debt and increasing the speed with which higher interest rates are reflected in debt interest costs.”
According to Redwood, projections from the US Congressional Budget Office (CBO) and the UK’s Office for Budget Responsibility indicate that a one percentage point increase in short- and long-term interest rates would result in a 0.5% increase in government borrowing in 2024 for both countries. As more of the debt becomes due, the effect on annual borrowing would also rise, reaching between 0.7% and 0.8% of GDP by 2027.
Redwood stated that if the markets are becoming concerned about governments’ fiscal standings, there is a possibility of entering a negative cycle. The markets are troubled by government debt, causing term premiums and interest rates to rise, further exacerbating the debt situation and increasing market apprehension.
Experts predict that bond yields will decrease again once the attackers are content that inflation has been controlled, interest rates are decreasing, and measures to reduce deficits are being followed. However, in the interim, the extremely high bond yields have the potential to cause a severe economic downturn.
Source: theguardian.com
