In the past few weeks’ headlines have been dominated by news of a “bond market sell-off” and “soaring yields” and this phenomenon isn’t limited to US markets. We have seen the same headlines across the world; UK, German, Italian and Japanese long-term bond yields all reaching historic highs in the past few weeks. At the same time, we see this rising yields often to blame for poor performance in global stock markets.
In this special edition of the Weekly Market Update we take a closer look at what’s driving these rising yields and the bond market sell-off and what this means for investors and the broader global economy.
The Basics
Running a country is an expensive business. Governments are almost constantly looking for sources of funding for various purposes, such as public projects, covering budget deficits and addressing economic crises and will often turn to the public sector and issue a bond. Government bonds have a specified maturity date when the principal amount is repaid to the bondholder and pay periodic interest payments to bondholders at a fixed or variable rate. The interest rate is known as the bond's yield and maturities can range from a few months to several decades.
For investors bonds are usually low risk, as they are government backed, easily tradable and can be a part of a diversified investment portfolio, as they tend to have a low correlation with other asset classes, such as stocks and usually offer higher return than cash.
While the capital is guaranteed at maturity bond prices can fall and rise during their lifetime as investors compare the coupon or interest payment of the bond with those available in the current market. As a general rule, as interest rates rise and new bonds are issued at higher interest rates the price of existing bonds will fall, and vice versa. A bond issued at a price of USD 100 with coupon of 3%, or USD 3, has a yield of 3% offers good value for investors while interest rates are at or below 3%. If interest rates rise, the bond in question becomes less attractive (as the coupon is fixed and better rates are now available) and the price will fall. If the price of the bond fell to 85 USD the coupon of 3 USD becomes a yield of 3.53%, and so on.
The Here & Now
As official interest rates have started to climb over the past 12 months, investors' expectations for bond returns, also known as yields, follow suit. This shift creates a compelling reason for investors to offload their existing bonds and seek out newly issued ones that promise more attractive interest payments. The consequence of this demand shift is a drop in bond prices. In a nutshell, when yields surge, bond prices dip. And we're currently witnessing a notable increase in yields: for instance, the yield on 30-year US government bonds, often referred to as Treasuries, recently hit 5%—a level not seen since 2007. Similarly, in the United Kingdom, 30-year bond yields reached a 5% milestone this week, marking their highest point in over two decades. German long-dated bond yields have returned to levels last observed on the cusp of the eurozone debt crisis in 2011. Italy's 10-year bonds saw their yields surge to 5% on Wednesday, reaching levels last experienced during the height of the 2012 financial crisis.
Rising yields and falling bond prices are significant indicators of changing market dynamics, impacting various sectors of the financial world, from investment strategies to government policies. The recent upward trend in yields, seen in key economies like the US, UK, Germany, and Italy, underscores the evolving landscape of fixed-income investments and the broader global financial climate. This shift invites investors to reassess their portfolios, while also serving as a barometer for economic and monetary policy changes in these regions.
In addition to this, recent comments from central bankers are doing little to help investor sentiment. This week Federal Reserve (Fed) Chair Jerome Powell said that while US inflation had fallen significantly it still remains above the Feds target of 2% but that their job of bringing inflation under control was being complicated by a US economy that was growing faster and was more resilient than the Fed had expected. “We certainly have a very resilient economy on our hands,” Powell said in a discussion at the Economic Club of New York. “Many forecasts called for the U.S. economy to be in recession this year. Not only has that not happened; growth is now running for this year above its longer-run trend. So that’s been a surprise.” Mr Powell reiterated his expectation that rates would most likely remain “higher for longer” which only added to this weeks bond sell-off and sent yields higher once more.
Wider Implications for Property Markets
Local government bond yields play a crucial role in shaping mortgage interest rates, and recent events in the UK vividly illustrate this interdependence. The unveiling of the UK's challenging "mini" budget by former Prime Minister Liz Truss in September last year sent shockwaves through the bond market. Her proposal to borrow substantial sums to finance tax cuts left bond investors worried about the sustainability of the country's finances. This unease triggered a sell-off in UK government bonds, known as "gilts," causing yields to surge and, in turn, driving up mortgage costs. By the start of November 2022, the average interest rate on a two-year fixed-rate mortgage had skyrocketed to 6.47%, as reported by Moneyfacts, marking the highest level since the depths of the 2008 global financial crisis.
This abrupt increase translated into hundreds of pounds added to monthly mortgage payments. Some homeowners, fearing higher mortgage rates, rushed to refinance their fixed-rate loans ahead of schedule, even incurring financial penalties to do so. While mortgage rates initially receded after the initial turmoil, recent data from Moneyfacts indicates that they have climbed back up to 6.47% this month. In the United States, where mortgage rates often align with the yield on 10-year Treasuries, a 0.27 percentage point surge in that yield since late September has pushed the average interest rate on a 30-year fixed-rate mortgage to 7.31%, a level not seen since 2000, according to government-backed mortgage provider Freddie Mac's announcement. These fluctuations underscore the intimate connection between government bond yields and the affordability of housing loans for consumers on both sides of the Atlantic.
Stock Markets
The surge in government bond yields is now casting a looming shadow over stock portfolios. Historically, when government debt yields rise, stocks tend to lose value, primarily because investors can attain higher returns and a stable income from less volatile, less risky assets. Consider the 10-year Treasury yield, currently at 4.78%, which surpasses the average annual dividends paid by companies within the S&P 500 index more than twofold. Recent weeks have witnessed stock indexes on both sides of the Atlantic experiencing declines. The S&P 500 and the tech-heavy Nasdaq Composite (NDX) have dipped by 4% and 2.3%, respectively, ever since the Federal Reserve's announcement late last month of a potential rate hike this year and a reduced number of anticipated rate cuts in 2024. In Europe, the STOXX Europe 600 and London's FTSE 100 have seen losses of 4.5% and 4.3%, respectively, during this period.
Stock markets have encountered additional headwinds in recent weeks due to surging oil prices, trouble in the Middle East, a weakened Chinese economy, and the looming specter of another government shutdown in the United States. Furthermore, the elevated official interest rates in both America and Europe have increased the cost of borrowing for businesses, adding yet another layer of pressure on equities. In this environment of rising yields and economic uncertainties, investors are navigating an intricate landscape, where the intersection of bond markets and stock markets plays a pivotal role in shaping investment strategies and outcomes.
In Summary
In the midst of recent headlines about soaring government bond yields and their potential impact on financial markets, it's important to remember that these market dynamics, while causing short-term turbulence, also present opportunities for investors and positive developments for the global economy.
First, let's understand the basics: Government bonds are essential tools for funding public projects, addressing economic crises, and maintaining government operations. For investors, these bonds offer a relatively low-risk option that can be integrated into diversified portfolios, often delivering higher returns than cash. While bond prices can fluctuate during their lifetime due to shifts in interest rates, the recent increase in yields signifies changing market dynamics.
Now, as official interest rates have started to rise, investors have seen the yields on government bonds surge. While this has led to a temporary dip in bond prices, it's a testament to a resilient and growing global economy. The recent increases in yields, witnessed in major economies like the US, UK, Germany, and Italy, highlight the evolving landscape of fixed-income investments and the broader financial climate. This environment encourages investors to reevaluate and optimize their portfolios while providing valuable insights into evolving economic and monetary policies.
Furthermore, the recent statements from central bankers, such as Federal Reserve Chair Jerome Powell, acknowledging the strong and resilient state of the US economy, indicate that we are on a path of continued economic growth and stability – against all odds it would seem! While higher interest rates may have led to a bond sell-off, they also reflect confidence in the economy's strength. This aligns with a global context where rising bond yields and changing market dynamics ultimately offer investors a chance to adapt and thrive.
In this shifting landscape, it's crucial for investors to stay informed and agile, adjusting their strategies to embrace the potential opportunities that accompany evolving market conditions. While challenges persist, the intersection of bond markets and stock markets continues to guide us toward an ever-changing but promising financial future.
[Disclaimer: The information provided in this blog post is for educational and informational purposes only and should not be construed as financial advice. Consult with a qualified financial professional before making any investment decisions.]
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