The worst bond market in 236 years
There has never been such a prolonged period of losses in the bond market as in the last three years. Indeed, it is challenging to determine the accuracy of the figures from the early postcolonial years. For example, how often were bonds traded during the War of 1812? Nevertheless, this statistic is shocking, the worst in 236 years. It serves as a reminder of the scale of an inflationary shock and an increase in interest rates that few had seen coming. The mini-crisis last March, which led to the bankruptcy of Silicon Valley and three other regional banks, is likely the beginning of a potentially more extended crisis.
This also highlights the growing anxiety on Wall Street regarding the increasingly precarious state of the U.S. government’s finances. Massive and seemingly endless deficits, the result, among other things, of Republican tax cuts and Democratic investments in green energy, appeared acceptable when the Federal Reserve kept interest rates near zero and purchased tens of billions of dollars in Treasury bonds each week. Free money masked many problems.
However, the calculation becomes more delicate with a 5% interest rate. The supply of bonds that the government needs to sell to finance its deficits is accumulating alarmingly. It could overwhelm what has long been considered insatiable demand for the world’s safest investment. The verdict is overwhelming: there is too much debt.
As a result, the price of 10-year Treasury bonds, a key benchmark for all economic borrowing costs, has collapsed, reaching its lowest level in 16 years. In other words, investors are demanding a discount to buy the debt, a dynamic amplified by the sudden exit of the Fed from the market. Quantitative easing, as the Fed’s bond-buying program was called, became untenable once policymakers deemed inflation the number one enemy. Central banks in Brazil, China, Japan, Saudi Arabia, and elsewhere also halted their purchases of U.S. bonds. In some cases, they started selling outright. The void left by central banks is again giving traditional financial forces, such as banks, hedge funds, and insurers, more power.
This is not a default by the United States on its debts. The periodic noise around the debt ceiling and government funding delays is, for now, at least, just noise. The real concern is that by pursuing a fiscal policy that drives yields to unsustainable levels to finance exponential debt, Washington is putting pressure on businesses and consumers, threatening economic growth. This happened last winter with SVB and is likely to happen again in the coming months. The 10-year yield reached 4.89% last week. Two months earlier, it was hovering around 4%. During the pandemic, it was only 0.3%.
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Another surprising reference is that at one point in the last quarter, the rise in yields was the largest since the one preceding the 1987 stock market crash. Once again, difficulties began to ripple through stocks, albeit to a much lesser extent. Corporate bonds also declined, and the dollar appreciated against most other currencies. Even oil, mainly immune to broader economic forces throughout the summer, was drawn into the bond market vortex last week, registering losses that ended a month-long rally.
After years of stability orchestrated by the Fed in the bond market, with benchmark yields hovering around 2%, this had become the new normal. The United States and much of the rest of the world had entered an era of low growth and low inflation in the aftermath of the 2008 financial crisis, so low-interest rates made sense. We had the lowest global interest rates in 5,000 years during this period.
But the world has changed, and new economic forces will keep yields high for years: climate change, the transition to green energy, deglobalization, demographic changes, and, of course, the ever-increasing supply of government bonds. We are in a world where the cost of capital is continually higher, which has consequences.