At the moment,the yield on 10-year bonds is 3.35 per cent,having started the year at 1.5 per cent. It is conceivable that those bonds will yield something above 4 per cent by the first half of next year. Two-year US Treasury notes are yielding 3.5 per cent,their highest level since 2007.
It is not just government bonds whose yields are spiking. Funds investing in high-yielding debt (often referred to as “junk bonds”) are experiencing massive outflows as the spreads between the yields on the sub-investment grade debt they are invested in and those of government bonds have blown out and generated double-digit losses for the investors in the funds.
Yields on junk bonds started the year around 4.3 per cent but have since soared to more than 8.5 per cent,with the spread above 10-year government bonds rising from about three percentage points to more than five percentage points.
The surge in interest rates around the world has also almost ended one of the more peculiar developments in financial markets of the past decade.
As the policy rates of the European and Japanese central banks sank into negative territory after the 2008 financial crisis a massive stock of negatively yielding debt emerged. Even some European corporates were able to entice investors willing to pay for the privilege of owning their debt.
The amount of negatively yielding debt peaked at $US18.4 trillion late in 2020,in response to the extraordinary measures central banks took in response to the pandemic but,as interest rates have risen rapidly this year,the stock of that debt has dropped to negligible levels.
The income losses built into those bonds by the negative yields would now be compounded by the capital losses generated by the higher yields in the market.
It is apparent with hindsight that investors underestimated the Fed’s resolve and,more recently,that of its peers as they have been confronted with the highest inflation rates in decades. The US inflation rate is 8.5 per cent,the eurozone’s 9.1 per cent and Australia’s is 6.1 per cent – its highest level in three decades – and is still rising.
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Indeed,US yields were starting to ease slightly until the Fed chair,Jerome Powell,delivered his ultra-hawkish speech at the Jackson Hole conference in Wyoming late last month. Thesharemarket tanked instantly and bond yields began rising again as the implication of his comments on the pace and duration of this rate-hiking cycle sank in.
The shift in the major banks’ monetary policies represents one of the biggest and most abrupt tightening of monetary policies since the 1970s,with the speed at which rates have been rising and the impact of the steady withdrawal of liquidity as the Fed shrinks its balance sheet (by not reinvesting the proceeds from maturing securities that it bought during its various bouts of post-GFC quantitative easing) clearly taking equity and bond investors by surprise.
Today there’s nowhere to hide,with all the main financial markets deflating and awash with red ink as the central banks’ belated but increasingly aggressive efforts to bring inflation under control continue.
How that will play out in a world that,post-pandemic,is awash with debt is the multi-trillion-dollar question.
While corporates and households in the major developed economies appear to be in relatively good shape,there are generations that have never experienced inflation rates at these levels or interest rates that have risen so rapidly and sharply,with some distance to go before they peak.
Emerging economies,and Europe,are being hit by the combination of increasing rates and the stronger US dollar,which increases the cost of mining and agricultural commodities as well as the cost of servicing and repaying US dollar-denominated debt.
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There’s also,of course,an energy crisis in Europe and elsewhere,sparked by Russia’s invasion of Ukraine and the West’s sanctions and Russia’s responses to them,that is adding to global inflation rates and the pressure on businesses and households.
For investors,bond markets used to be the safe haven in turbulent times for riskier markets,like sharemarkets. Today there’s nowhere to hide,with all the main financial markets deflating and awash with red ink as the central banks’ belated but increasingly aggressive efforts to bring inflation under control continue.