The $25-trillion US bond market is perhaps not the most exciting of topics, but it is critical to the functioning of the global economy. The US 10-year is effectively the global risk-free benchmark, underpinning the borrowing costs of everything from mortgage rates to emerging markets.
Investors in this market have had a torrid few years, with yields rising from a historical low of 0.66% in April 2020 to 4.88% this week (yields move inversely to prices), its highest level for 16 years.
But even this bleak longer-term picture could not have prepared investors for the shock of last week, with the 10-year treasury shooting up almost 15 basis points.
Even more extreme was the usually staid and implacable longer end of the curve; the US 30-year yield has risen an extraordinary 64 basis points in the past month, with almost a third of that coming last week alone.
What is going on here? On this, there are four interpretations.
First, this is a consequence of the Federal Reserve signalling it is willing to keep interest rates “higher for longer” to get inflation down.
From looking at previous rate hiking cycles, history shows that the 10-year rate usually peaks between 50-100 basis points above the peak overnight rate, as investors demand a “term premium” for holding longer-term debt.
With the Fed fund rate currently 5.25-5.5%, this indicates the sell-off may have further to run.
Second, some argue this is simply reflecting a more positive longer-term growth outlook for the US economy.
Last week’s surprisingly resilient jobs market data out of the US, which showed significantly stronger payroll gains, could have triggered the sell-off.
If this is true, then it is possible that interest rates will never go back to the ultra-low level they were mired in for the decade after the financial crisis.
Perhaps bond yields are now simply normalising, albeit much quicker than expected.
Third, there are arguments around the supply of treasury bonds, largely due to a glut of issuance from the US government to fund Republican tax breaks and the Democratic-led investment in green energy.
All this will come on top of the existing US debt pile which has grown exponentially, from a mere $5-trillion in 2008 to $25-trillion today.
If this seemed manageable with interest rates pinned at zero, at 5%, the maths looks very different. The interest rate expenditure on this debt mountain alone will be astronomical, even without the aggressive additional borrowing.
“There’s just way too much debt,” says Ed Yardeni, an economist and founder of Yardeni Research.
Finally, such a surplus of issuance is compounded by the Fed itself moving from buying bonds in the market to being a net seller, in its programme of QT (quantitative tightening), as it looks to unwind the vast bond holdings it accumulated after the financial crisis during QE (quantitative easing).
This has sucked up around $1.7-trillion of liquidity out of the commercial banks, according to Bloomberg estimates, which are the main marginal buyers of treasuries.
If supply increases then the price must go down, and yields must go up.
Bad news for emerging markets
The reality is that it is probably a mix of all four. Either way, these moves in the bond market are not good news for anyone, be they in the US or in emerging markets like South Africa.
For those looking to refinance a mortgage or buy a new home, the monthly expenditure will be brutal.
Banks which have been sitting on vast bond holdings will be nursing massive losses and therefore will cut their lending appetite.
Corporates, which largely have a floating rate cost of debt, will face substantially higher interest payments.
Highly indebted countries like South Africa, which run chunky budget and current account deficits, will face sharply higher borrowing costs.
For the ANC, already facing a deteriorating fiscal outlook, these dynamics from the US could not have come at a worse time.
An eerie calm has persisted over other parts of the financial markets, such as equities, where moves downward have been steady but marginal by comparison.
It is quite possible that this will not continue.
John Authers, writing on Bloomberg, compares these bond dynamics to the lead-up to the single worst day in equities in history – the infamous “Black Monday” of 1987.
The bond market turmoil in the years up to that day in October had been in contrast to the relative calm in equity markets, all of which unwound spectacularly in a single day, with the stock market tanking 20%.
What seems to be clear is that the economy, and therefore earnings, are fundamentally stronger than previously thought and are taking longer to be affected by the higher borrowing costs.
This could be a result of the excess savings and demand that has lingered post the Covid lockdowns.
Unfortunately, however, this can’t persist forever; as with the laws of physics, so are the effects of higher interest rates.
“We’re getting pretty close to the level where something could break,” says Yardeni.
A key level for him is 5% on the 10-year Treasury. Surpass that, he says, and a recession and collapse in equities start to look unavoidable. DM