Global Financial Markets: Rising Treasury Yields and Bond Market Challenges

In short:

• This article highlights the current concerns about global financial stability, focusing on the impact of rising Treasury yields, surging bond prices, and escalating sovereign debt worldwide. 

• On the demand side, inflation and interest rate hikes, as well as inflation risk, play a role. On the supply side, the Federal Reserve's decision to halt quantitative easing has significant implications, as the Fed becomes a net seller of Treasury bonds.

• The rising yields have significant implications for various areas of the economy, such as housing prices and bank stability

With possible ‘higher for longer’ interest rates, surging bond yields and rising global sovereign debt, global financial stability is currently on the radar for many. Especially now with the long looming recession fears. We will look at what is happening in the bond market and how this affects the real world.

Overview of the US Bond Market

The United States has the world’s largest fixed-income market. In 2022, $55.1 Trillion worth of bonds, which includes treasury securities, corporate bonds and mortgage-backed securities and treasury, were outstanding. $23 Trillion of this is from its government Treasury securities issuance, which the government uses to fill its $1.7 Trillion budget deficit. The last time the US Government held a budget surplus was in 2001, with the following year setting the downward trend which would follow over the coming years.

This can largely be attributed to the government’s defence spending, which, since the September 11, 2001 attacks, has been on the rise and mainly financed through debt. The US’s involvement in post-9/11 wars from the period 2001 to 2022 has a combined financial cost of $8 Trillion (statistics on the human costs of the war can be read here.) These costs will continue to rise due to the US’s involvement in global geopolitical conflicts.

The importance of the Treasury securities lies in them being seen as a safe asset as the US government, which has never defaulted on its debt obligations, is their guarantor. This was also supported by the ‘AAA’ rating, which its long-term treasury debt received from the ratings agency Fitch (which was recently downgraded to ‘AA+’). Alongside this, ownership of treasuries is widespread, as shown by the graph below.

In the last few weeks, however, there has been turmoil in the bond market, with bond prices tumbling and as a result, their yields rising. On October 19^th, the US 10-year Treasury note reached a 16-year high of 4.98% after weeks of bond yields surging. This can be attributed to both demand and supply factors.

Source: The Financial Times

In terms of demand-side factors, inflation and interest rate hikes play a role. As the Federal Reserve, along with other central banks across the globe, hike interest rates to battle stubborn inflation, this pushes bond prices down. Alongside this, inflation risk also adds to the demand side factors. As inflation surges globally, there is uncertainty over how and when central banks will be able to tame it, leading to investors requiring a higher risk premium. 

From the supply side, the most significant factor is the halting of quantitative easing by the Fed, as the graph shows that the Fed is currently a net seller of treasury bonds. 

Why is it so important?

As the longer-term yields are used as a reference rate (the hypothetical risk-free rate), this means that rising yields directly increase the rates for debts with similar maturities.  Here are three areas in particular to look out for:

Banking stability

With the fallout of Silicon Valley Bank still at the forefront, the question is how this affects banking stability. The higher interest rate environment, on the one hand, is beneficial to banks as they can make greater profits on the spread of their loans. However, as is the case with Silicon Valley Bank, most banks have balance sheets, of which a large portion comprises Treasury Bonds. The rising yields mean the value of the underlying asset is falling, which is problematic because selling the bonds would mean the bank making a loss. However, this concern is directed mainly towards smaller regional banks, who are less diversified and have been able to take advantage of loans backed by US tax payer’s money to keep their books balanced. This segment, which includes banks such as Regions Financials and Fifth Third Bancorp, has also experienced falling stock prices in October, with many concerned about their decreasing profitability as loan growth has slowed down with rising interest rates.

Housing Market and Household Debt

Higher mortgage rates in the US have been soaring with the rise of bond yields, reaching a 23-year high of 7.49% in the first week of October. In the Netherlands, the mortgage rates have also been climbing up, reaching a 5-to-10-year fixed rate level of 3.7% this quarter. Despite this, there has been an increase in the number of mortgage applications in 2023, according to the National Association of Real Estate Agents and Appraisers (NVM).  Although this is coupled with a slight fall in housing prices, overall, there is concern over consumer purchasing power as the combination of interest rate rises, inflation surges and an ongoing energy crisis could lead to devastating effects for households. 

If we turn back to the United States, we can see similar concerns. Credit card debt reached an all-time high of $1Trillion, with an annual average rate of 22% and delinquency rates which are creeping upwards. This, paired with the factors affecting their European counterparts, is not encouraging of an optimistic economic outlook going into 2024, especially as consumer spending begins to slow down. 

Government Debt

Concerns over the ability of governments worldwide to make interest payments on their debt are coming more to the forefront as we continue to see the evolution of interest rates. This comes after sovereign debt soared during the Covid 19 pandemic, as many governments distributed support packages to both individuals and businesses during this period. Alongside this, military spending by governments of several OECD countries is expected to continue to expand in the coming years in light of recent geopolitical developments. A result of this is that governments will be required to spend larger fractions of their GDP in order to pay interest on this debt.

When looking at this from the perspective of more developed, emerging and frontier markets, the concern is related to how the situation will evolve over a longer horizon. The case of developing countries is one which will be discussed in an upcoming article. 

With all this being said, what is evident is that we will all need to get used to a ‘new normal’, where you can’t have your cake and eat it too when it comes to interest rates.

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