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The global bond market is having a historic year.
The yield on the 10-year US Treasury bond, a proxy for borrowing costs, moved above 4% on Wednesday for the first time in 12 years. That bodes ill for Wall Street and Main Street.
What’s happening: It hasn’t been a pretty year for US stocks. All three major indexes are in a bear market, down more than 20% from recent highs, and analysts are predicting more pain. When things are so bad, investors seek safety in Treasury bonds, which have low yields but are also low risk (as they are loans to the US government, Treasury notes are seen as a safe bet with little risk of not being paid back).
But in the economic turnaround of 2022, even that safe haven has become somewhat treacherous.
Bond yields or yields rise as their prices fall. Under normal market conditions, rising yields mean there’s less demand for bonds, as investors want to put their money into higher-risk (and higher-reward) stocks.
Instead, markets are falling, and investors are pulling out of risky stocks, but yields are rising. What does it give?
Blame it on Fed. Persistent inflation has pushed the Federal Reserve back by aggressively raising interest rates, and as a result, US Treasury bond yields have risen.
Economic turmoil in the UK and the European Union has also caused the value of both the British pound and the euro to drop dramatically against the US dollar. A stronger dollar usually coincides with higher bond rates.
So while we would normally see a rise in the 10-year yield as a sign that US investors have a rosy economic outlook, this is not the case this time. Gloomy investors are predicting more interest rate hikes and a greater chance of a recession.
What does it mean: Portfolios are hurt. Vanguard’s $514.5 billion Total Bond Market Index, the largest U.S. bond fund, is down more than 15% this year. That puts it on track for its worst year since its inception in 1986. The iShares 20+ Year Treasury bond funds (TLT) (TLT) are down nearly 30% for the year.
Stock investors are also eyeing Treasuries nervously. High yields make it more expensive for businesses to borrow money, and this additional cost can reduce earnings expectations. Companies with a significant level of debt will not be able to afford higher financing costs.
Main Street doesn’t have a break either. The high return on the 10-year Treasury means more expensive borrowing on cars, credit cards and even student debt. It also means higher mortgage rates: The surge has already helped push the average rate on a 30-year mortgage above 6% for the first time since 2008.
In depth: However, investors are more nervous about the near future than the longer term. This has led to an inverted yield curve, where interest rates on short-term bonds are higher than those on long-term bonds. The inverted yield curve is a warning sign that has correctly predicted almost every recession over the past 60 years.
The curve first inverted in April, and again this summer. The two-year Treasury yield has risen over the past week and is now above 4.3%, deepening that range.
On Monday, a BNP Paribas team predicted that the inverse spread between two-year and 10-year Treasury yields could widen to its highest level since the early 1980s. Those years were marked by sticky inflation, interest rates close to 20% and a very deep recession.
What’s next: The bond market could face fresh volatility on Friday following the release of the Federal Reserve’s pro-inflation gauge, the August Personal Consumption Expenditure Price Index. If the report beats expectations, expect bond yields to be even higher.
The Bank of England made an emergency intervention to maintain economic stability in the UK on Wednesday. The central bank said it would buy long-term UK government bonds “on any scale necessary” to prevent a market crash.
Investors around the world have dumped the British pound and UK bonds since the government on Friday unveiled a massive package of tax cuts, spending and increased borrowing to get the economy moving this winter and protect households and businesses from high energy bills. says colleague Mark Thompson.
Markets fear the plan will push up already persistent inflation, forcing the Bank of England to raise interest rates to 6% next spring, from 2.25% currently. Mortgage markets have been in turmoil all week as lenders have struggled to rate their loans. Hundreds of products have been recalled.
“This repricing [of UK assets] has become more significant over the past day, particularly affecting long-term UK government debt,” the central bank said in its statement.
“If the dysfunction in this market were to continue or worsen, there would be a material risk to the UK’s financial stability. This would lead to an unfair tightening of funding conditions and a reduction in the flow of credit to the real economy.”
Many final salary, or defined benefit, pension funds were particularly affected by the massive sell-off in longer-dated UK government bonds.
“They would be wiped out,” said Kerrin Rosenberg, UK CEO of Cardano Investment.
The central bank said it would buy long-term UK government bonds until October 14.
A sharp decline in bond prices may signal doom and gloom in the economy, but some analysts say short-term bonds are still more attractive than stocks.
“Record low returns have kept fixed income in the shadow of equities for decades,” said Andy Tepper, managing director of BNY Mellon Wealth Management. “But the aggressive shift in Fed policy is beginning to change this.”
Central banks around the world have responded to high inflation by raising interest rates, and bond yields have risen along with them. The two-year US Treasury bond currently yields nearly 4%. That’s still a relatively low yield, but better than the S&P 500’s dividend yield of about 1.7%.
“For the first time in many years, bonds are an attractive investment option. In addition to providing diversification over stocks … now you get paid to own them,” Barry Ritholtz of Ritholtz Wealth Management wrote Wednesday.
Consider the alternative: The S&P is down more than 20% year to date.
The US Bureau of Economic Analysis releases its third estimate of second-quarter GDP and weekly US jobless claims.