The US 10-year yield reached its highest level in 16 years, leading to one of the worst bear markets in bond history. As the bond market remains one of the largest markets, it has impacted other markets, such as stocks. Despite its reputation for conservative investing, this market is experiencing one of its worst bear markets. We are going to take a closer look at the why as well as the impacts of this increase in the rate of return. This is in order to better understand the environment in which we are.
What is the bond market?
Before explaining the impacts of the surge in the 10-year yield rate, we will mainly talk about the principle of a bond to fully understand the concept.
The bond market is that of borrowing. This is where we will issue, buy and sell bonds (debt securities). It is more important than the stock market, which is why we often say that it is the leading market, the one that tells the truth. To put it simply, the government or companies will issue bonds/debt securities. This is for the purpose of financing development or expenditure. Here, we will focus on government bonds.
When an investor buys a debt security, he lends money to the borrower and receives compensation via the interest rate in return. Then, on the maturity date, he gets his initial capital back. We also talk about fixed income because we know the rate of remuneration in advance and we recover the initial amount of the loan if there is no bankruptcy. Bonds are debt securities while stocks are equity securities.
Money Market vs. Bond Market
We have both the money market and the bond market, the main difference is in duration. The money market will specialize in short-term debt securities, i.e. treasury bonds generally with a duration of less than one year, while the bond market will represent more bonds with longer maturities (example: 5-10-20 years). The 10-year yield rate, which remains one of the most observed rates, represents a long maturity.
The performance of US bonds
Bonds are considered more conservative securities, the yield remains lower than the futures stock market.
They are considered safer so they are used for more conservative profiles. One of the most used portfolios for diversification is the 60/40, i.e. 60% stocks and 40% bonds. The 60/40 portfolio helps limit the largest drawdowns when we have a recession or market declines. The reason is that bonds tend to outperform during recessions compared to other asset classes.
The mechanism is simple to understand. When we are in recession, central banks will tend to lower rates in order to make access to borrowing more accommodating to stimulate growth again.
Bonds are linked to the interest rate since they have the status of debt. When rates rise, the value of bonds falls. The rates and bonds market will be stimulated by several factors such as:
- The growth
Why are bonds experiencing the worst bear market in their history?
Since 2021, bonds have continued their descent into hell. That is to say, they are experiencing the worst bear market in several decades. We are talking here about long-term bonds. The first reason remains because of inflation. To control inflation, the central bank will have to raise its key rates, which implies a restrictive monetary policy. Therefore, in a rate hike cycle, they will go up.
However, with the rise in key rates, short-term maturities on the money market will attract more investors. We can see this in the following curve.
As the expirations are short-term, investors benefit from both getting back 100% of the capital in a shorter duration but they also benefit from a high interest rate since the rates on the money market are closer to that of the key rate. This is also one of the reasons why long-term bonds are experiencing one of the worst bear market. Short-term rates are higher than long-term rates, so investors will favor short expirations over longer maturities because the rate of return is more favorable. Consequently, this puts pressure on the 10-year rate to rise so that it becomes equally attractive.
The problem of high supply and low demand
Let’s discuss the second major problem, a very large supply of US bonds. The major factors that ensure that we have a significant offer are: the QT quantitative tightening + short-term rates more attractive than long-term rates + the exit of foreign investors + new bond issues following the increase in the debt ceiling limit.
- THE quantitative tightening assumes that the central bank will not repurchase certain maturities every month. held in its balance sheet Consequently, the balance sheet declines and liquidity is increasingly weak.
- The exit of investors is becoming worrying, which leaves room for an increasingly large supply. We can see the example with China.
- The other element remains the fact that the debt ceiling limit has been raised, which implies that new issues have been auctioned. Therefore, supply has increased in an already difficult context.
All of these elements combined with the initial problem of inflation imply that rates are raised to attract investors and remunerate them in relation to risk at the same time.
Since long-duration bonds are riskier, a higher rate of return is required to compensate for the risk. To rebalance everything, it would be necessary either:
- Inflation falls to reduce monetary policy pressures
- Long-term rates are becoming more competitive than short-term rates
- Central banks stop quantitative tightening program QT
- Central banks buy bonds to reduce the available supply if the drama worsens
Issues on the economy
The rise in rates is problematic since it makes access to borrowing less accessible. Even if it is voluntary in order to slow inflation as best as possible, it can have devastating effects later. As the cost of borrowing becomes more expensive, this may limit businesses from expanding through credit. This is particularly the case for businesses that are more dependent on credit to grow. On the other hand, it can reduce margins and therefore affect the company’s profit. This is also why we have some turbulence on the stock market which represents companies.
At the individual level, high rates can limit access to property purchases. And it will also impact those who will have to renew their mortgage with a higher interest rate. All on the condition that long-term rates do not fall. This will involve much higher monthly payments. These are just a few examples. The variation in rates makes economic cycles sometimes resulting in recessions or an accident.
The other important element remains the holders of the bonds at a loss. As US bonds are considered safe, they are also massively held by large investors. We are talking here about financial institutions, the central bank, pension funds, companies… However, long-term bonds have a drawdown of around -46% since the last highs on US bonds.
So far, the latest decline in bonds during September/October has been offset by the strength of the US dollar. However, if the US dollar falls, and the rate of return does not fall enough, this may make the loss unsustainable just like in March 2023. Here are the unrealized losses by large holders.
A “remake” of March 2023 ?
As there are fewer deposits in banks, money placed in government bonds can cause an imbalance. This is linked both to unrealized losses on US bonds with a long maturity and the lack of parallel deposits. This mainly concerns banks which take more risk and leverage. This was the case for regional banks with the intervention of the FED in March 2023. Moreover, we can see in the graph below the risk which increases via the credit default swap.
10-year rate forecasts
We have several forecasts that are being made across the industry. There is Bill Ackman who supports the fact that rates will continue to rise in the coming years. We have Larry Fink (Blackrock) who supports a 10-year rate at 5% or there is Jamie Dimon (JPMorgan) who supports a rate of return at 7%. We have already gotten closer to 5% since the rate has soared towards 4.88%.
As the central bank pauses to see the effects of tight monetary policy, the rate hike cycle is closer to the end than the beginning. Real rates are positive, which means being sufficiently restrictive. For this economic cycle, the 5% level could become a very important resistance. On the other hand, there is an incredible consensus on the end of the bond market in the media and on the networks. And consensus is not always best. We can see that the rate has returned to the same levels as before the 2008 financial crisis.
The elements that will influence the evolution of the rate of return
The drop in oil prices should limit the potential for inflation but it is still the problem of supply (too high) which remains real. The simple fact of stopping the quantitative tightening program would be positive enough to limit the increase in the 10-year yield rate. For the rest, in the event of a tragedy like a credit crisis, the FED should react as it has done in the past. A pivot from the FED would be even better. We are still talking here about a leading market which has a volatility worthy of a shitcoin which can have devastating collateral impacts. If it goes too far, it would be surprising not to have intervention.
That said, for the next few years, there are several reasons that could preserve the 10-year rate of return to return to the same levels such as deglobalization, fiscal deficit which forces the issuance of more bonds, a lack of interest from foreign investors, ‘inflation…
Investors will again be attracted to long-term bonds when the central bank’s discourse becomes more flexible and less restrictive. In this type of situation, the high rate of remuneration combined with a less hawkish message should attract investors again. As soon as investors start buying again, this will subsequently ease rates for a time.
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