Bonds in the Driving Seat

It’s been a busy week for markets, with a deluge of data kicking off the new quarter and getting asset classes moving. Sterling has managed to keep its head above some big levels following the better-than-expected service sector data from Wednesday, but most of the moves in the currency markets are being driven by the US – and the US bond market in particular. Yields on US bonds hit highs not seen for more than a decade this week – and on the 10-year bond, the highest levels since before the global financial crisis – the move is being driven by investors completely re-assessing when, and how quickly, interest rates will start to come back down. High bond yields mean a drag on all of us; from government debt servicing costs, company borrowing, household mortgages etc. The concern for governments is that they’re going to be paying more to service debts, whilst tax income from a slowing economy will be smaller, which means they have bigger deficits to finance, which means more borrowing! Add to this that central banks aren’t now buying up government debt like they used to (and are actually trying to sell down what they’ve got) and you end up with other investors that are buying up government debt demanding more compensation for their efforts, in the form of higher yields… and so the cycle continues.

So should we worry…? Well the good news is that with bond yields staying high, there’s less pressure on central banks to raise rates, because the market is doing their work for them – in fact the market is pricing just a 30 percent chance of a final rate rise this year, down from 40 percent last week and 50 percent the week before, so we’ll call that a good thing. Equity markets won’t like it too much, because attractive returns in ‘risk free’ government bonds make leaving money in relatively more risky stocks less appealing, and we’re seeing that already with the stock market sell-off of last quarter. Another area of focus will be on banks, which are major holders of government bonds and, as we saw earlier in the year with SVB, the bonds that banks are holding will be carrying big negative mark to markets (unrealised losses) which might in turn mean banks have to hold onto more capital and which will reign in their lending appetite, which would cascade back into the corporate and consumer financing markets. So, we need to see where this goes, but the market has called time on the hope that interest rate charts would look like Mount Fuji – and are now looking more like a Table Mountain situation, which could in turn cause businesses and consumers to have to re-think their financing options too.