What’s Going On in the Bond Market?

Key Takeaways

Bondholders have been enduring a difficult time, as you’d expect with the way interest rates have moved lately. The only sectors of the bond market that show gains year to date through the end of September are cash equivalents and corporate bonds. These tend to be the most economically sensitive of bonds and therefore also the most stock-like.

The reality is that you have to go back before the 2007-2008 Financial Crisis to find bond yields this high, and many investors just aren’t used to it. Two-year Treasury notes are offering 5.19%, 10-year bonds 4.83% and 3-month bills 5.62%, as of Oct. 17.

What’s Driving Long-Term Bond Yields Higher?

There are a number of factors (or a combination of factors) that could be affecting yields on long-term bonds.

1. Increasing economic growth premium

2. Increasing inflation premium

3. Increasing credit premium

4. Supply/demand imbalances

Factor 1: Increasing Economic Growth Premium

I can’t believe that worries about too-hot economic growth are driving yields higher. It’s true that the economy has remained more resilient than many expected (including me), but the reality is that most leading indicators point down, not up.

With a slowdown—to say nothing of an outright recession—on the horizon, economic conditions suggest bond yields should be falling, not rising.

Factor 2: Increasing Inflation Premium

Of course it’s true that higher inflation and resulting Federal Reserve (Fed) rate hikes explain the rise in yields in 2022, but it’s hard to see what changed in the inflation picture to cause the sharp bond sell-off earlier this month.

For example, if you look at fed funds futures pricing, it suggests that there’s still some possibility of one more rate hike in November or December. But that probability has been falling in recent weeks. This suggests that bond investors think inflation and the Fed are less of a concern going forward.

Having said that, incoming inflation data will influence those probabilities, so this isn’t written in stone. But the point is, it’s hard to see how the recent bond market sell-off is a result of current inflation and rate expectations.

Factors 3 and 4: Increasing Credit Premium and Supply/Demand Imbalances

Let’s take numbers 3 and 4 together. Increased supply and diminishing demand are definitely contributing to the current situation. This is somewhat counterintuitive because one would guess that the current level of yields would make bonds attractive relative to other investments and should, therefore, increase demand. But the exact opposite seems to be happening.

One very real reason for this could be the vacuum created by the Fed’s departure from its heavy purchasing during the period of quantitative easing. That takes away one big buyer in the market and empowers traditional forces in the financial markets to push yields around.

To explain why that’s relevant now, we are going to take a trip in the way-back machine to the 1980s. Then, famed Wall Street economist Ed Yardeni coined the term “bond vigilantes” to refer to some of the biggest bond buyers—banks, hedge funds and insurers—and how they pushed bond prices down and yields up in protest of, or to signal distaste with, the government’s monetary and fiscal policies.

Something like that could be happening again. Recall that in August, credit rating agency Fitch downgraded U.S. government debt, citing concerns with federal governance. Well, that was before the fight over the budget and the unprecedented eviction of the Speaker of the House of Representatives.

In terms of the debt itself, the latest Fed data show the debt-to-GDP ratio currently at around 120%. That’s actually improved since the pandemic peak but would otherwise be the highest debt burden relative to GDP (gross domestic product) since immediately after World War II.

At these high levels, rising bond yields mean interest expense (the cost to finance our debt) is likely to skyrocket. That could affect the economy in a very real way going forward as higher interest expense would necessitate even more borrowing, resulting in a cycle of higher debt and higher rates, crowding out other borrowers.

Whatever the root cause of surging bond yields, the negative effects are being felt now and could well continue to reverberate throughout the financial markets and the real economy for years to come.