Quick Bites | Rising Bond Yields Threatens Markets

Global sharemarkets have come under pressure as a sharp bond sell-off has taken hold. In recent days, we have seen the benchmark US 10-year Treasury yield above 4.6%. In Japan, we see their 30-year yield reaching 4% for the first time. In the UK, long bond yields have hit 28-year highs. In Australia, we note 10 year government bonds above 5.0% (at time of writing, 5.048%).

Source: Goldman Sachs

Inflation is the key driver of long bond rates, but there are many other drivers as well: inflation expectations; monetary policy (one could include specific programs such as Quantitative Easing under this heading); economic growth trends and the expected growth trajectory; and lastly, what we could term “fiscal health”, that is the issuance and supply by governments. Large fiscal deficits require increased debt supply, which requires higher yields to attract sufficient market clearing capacity.

Source: IMF, WSJ

Pressure on Bonds

Tumbling bond prices have pushed yields on government debt higher, lifting borrowing costs for governments, businesses and consumers alike. As mentioned, the main driver has been the surge in energy prices since the Middle East conflict started at the end of February, which has lifted inflation and talk of interest-rate increases by central banks. But concerns about the fiscal outlook in Japan and the UK have also added to the bond-market selloff in recent days.

Source: FT

In the US, federal debt held by the public just climbed above 100% of GDP for the first time since the aftermath of World War II.

The global picture

Countries across the globe are dealing with ageing populations and pressure to increase military spending. Taken together, the debt of advanced economies is growing as a percentage of their collective GDP, according to the International Monetary Fund. 

Source: Ed Yardeni

In this QB, we deal selectively with the issue in the interests of keeping the article “quick”. Key to recent trends is the inflationary pressure caused by the energy shock. Oil prices have climbed above US$105 per barrel after US-China talks failed to ease tensions surrounding the Strait of Hormuz blockade. Energy costs are flowing through to all sorts of products and services, evidenced by recent data for the month of April.

Source: Bloomberg

Investors are increasingly questioning whether richly valued equities can continue rising amid persistent inflation, elevated energy prices and tightening financial conditions, raising fears of a broader market repricing and potential stagflation risks.

The 2-month correlation between US equities and US 10y yields turned the most negative since the late 1990s (see chart below).

Source: Goldman Sachs

The equity market’s response to rising bond yields has tended to be closely linked to the source, speed, and starting level of the yield move. Since the start of the Middle East war and the ensuing energy price shock, markets have seen inflation rather than growth as the main source of macro shocks.

Rising yields are typically the result of either faster growth or rising inflation. Yields going up due to better growth are usually digested well by equities (as growth optimism can help buffer discount rate headwinds), whereas in an inflation-led rate environment the equity/bond yield correlation turns negative. Unlike the past, higher growth expectations due to micro (e.g. AI investment) rather than macro catalysts have supported equity prices since April.

The theoretical underpinning of the relationship between bonds and equities is fairly well understood. Rising bond yields due to inflation exert downward pressure on equity valuations. This is primarily through the discount rate used in DCF (Discounted Cash Flow) valuation models used by professionals.

As the “risk-free” rate rises, the cost of equity increases. This compresses the Present Value of future corporate cash flows. Furthermore, elevated yields compress the equity risk premium, attracting capital from equities and into fixed income to secure attractive, risk-adjusted returns. More intuitively, we understand that the rising cost of debt affects all economic activity, punishing borrowers and suppressing general economic activity.

Yields on all government debt are influenced by what investors think short-term interest rates (set by central banks) will average over the life of a bond. Investors, though, typically demand higher yields to hold longer-term bonds, due to the risk that inflation and interest rates could surge unexpectedly in the future.

Ed Yardeni’s opinion

Ed Yardeni, an investment strategist that I rate highly, said the US Fed should remove its easing bias at its June meeting, given that it is “no longer” appropriate in the current market environment.

“If the Fed fails to remove it, investors will conclude that the central bank is falling behind the inflation curve and will demand a higher inflation risk premium,” Yardeni wrote in a note. “We expect the Fed to hold rates unchanged at the June meeting and shift to a tightening policy stance.”

Higher rates in countries outside the US are weakening a key source of demand for Treasuries, forcing the US government to compete harder for buyers at a time of large fiscal deficits and persistent inflation concerns.

The view that the Fed may have to delay rate cuts or even raise borrowing costs is disrupting confidence in sharemarket valuations.

The new Fed Chair Kevin Warsh might make a difference: if he is able to contain long-term Treasury yields, perhaps through a new program of Quantitative Easing, the market would be soothed.

“By acting hawkishly, Warsh might have a chance of delivering what the White House wants: lower real-world borrowing costs,” Yardeni wrote. “Mortgage rates could fall, corporate financing would ease, and Trump can point to declining long-term yields as the economic win.”