Column: Good, Bad, and Ugly in Renewed Bond Rout – Mike Dolan

By Mike Dolan

LONDON – Financial markets are experiencing significant turbulence as long-term borrowing rates undergo a rapid recalibration, raising concerns about both the reasons behind this shift and its potential impact on bond markets.

Despite the Federal Reserve not signaling any immediate rate hikes, U.S. long-term bond yields have begun to climb steeply this month, leading to declines in interest-rate sensitive stocks. This trend suggests that the Fed may not be able to ease monetary policy as liberally as some had anticipated.

This week, ten-year U.S. Treasury rates surpassed 4.3% for the first time since October, approaching 15-year highs, and sending real, inflation-adjusted returns close to 2%, a level not seen since the fallout from the 2009 financial crisis. Additionally, the 30-year Treasury yield reached its highest point in 12 years.

While Fitch’s decision to lower the U.S. credit rating on August 1 may have sparked renewed anxiety in the bond market, many investors view it as a mere timing issue rather than the root cause. The impressive resilience of the U.S. economy—remaining strong even after the Fed’s aggressive rate hikes—has prompted analysts to consider whether the shift in economic dynamics post-pandemic is pushing long-term interest rates back toward pre-2008 levels.

Recent data, including robust retail sales, industrial production, and housing starts for July, have led forecasters to revise U.S. GDP estimates upwards. Initially, the consensus was that the Fed’s tightening measures would lead to a recession within a year, but the economy managed to accelerate at a 2.4% annualized rate through the second quarter, with signs of even stronger growth in the third quarter.

The Atlanta Fed’s real-time GDPNow model is currently projecting a 5.8% growth rate for the current quarter, marking a significant increase from just a month ago and representing the fastest pace since January of last year. Deutsche Bank, which previously forecasted a recession, has now more than doubled its third-quarter growth estimate to 3.1%.

With the labor market near full employment, the potential for increased U.S. trend growth is particularly encouraging after years of economic uncertainty following the Great Financial Crisis. While higher interest rates could persist, this scenario could enhance corporate earnings and investment prospects.

Conversely, some analysts are warning of a more negative scenario. The theoretical long-term real interest rate that supports both growth and stable inflation—often referred to as ‘R-star’—may be increasing due to rising debt levels and significant structural changes. Current Fed assumptions place R-star at approximately 0.5%, indicating a long-term policy rate of 2.5% when inflation aligns with targets. However, estimates suggest it may have risen as high as 1.5%.

This adjustment implies that a higher neutral interest rate in the U.S. could necessitate more aggressive monetary tightening from the Fed, potentially hindering short-term economic outlooks and forcing adjustments from the private sector, with aging demographics and rising fiscal deficits contributing to the trend.

Many attribute the resurgence in yields to increasing deficits during a time when the supply of bonds is swelling, as central banks reduce their balance sheets, which in turn requires the private sector to absorb the influx of additional securities.

The ongoing quantitative tightening by major central banks, compounded by diminishing demand for Treasuries from emerging market central banks due to geopolitical factors, exacerbates the supply issue. Consequently, the ‘term premium’ embedded in long-term bond yields—which has been depressed since the 2008 financial crisis—could increase even if the Fed halts further rate increases.

Experts predict that 10-year Treasury yields could approach 4.5%. Some argue that if the current environment reflects a return to pre-2008 conditions, the Fed’s policy stance could lean more toward neutrality than restriction, limiting future rate cut opportunities.

However, there remains the potential for a ‘duration crisis’, which could significantly impact the safe asset bond market without transitioning into a broader credit crisis. If the values of these safe assets decline sharply, making them riskier, the implications for credit and liquidity within the financial system could be severe. Analysts warn that if inflation stabilizes at 3% while the Fed’s neutral rate remains around 0.5%, the 10-year yield could push towards 5%.

In the current environment, creditors are experiencing the impact of increasing borrowing costs, with floating rate borrowers particularly affected. Fixed-rate borrowers will also face challenges when refinancing, leading to rising default rates, especially among leveraged loan issuers compared to their high-yield bond counterparts.

While these trends are unusual relative to the previous two decades, analysts anticipate their continuation in a landscape characterized by persistently high capital costs.