Why bond markets suddenly matter again

Until a few years ago, government bonds rarely made headlines. Despite most Western governments running deficits for years, lenders appeared happy to tolerate being paid relatively low levels of interest to buy bonds. As an asset class, government bonds played an important role as a calming diversifier against the more volatile stock market. They were seen as relatively safe and dependable.

Since Covid, though, the situation has become more complicated. Recent headlines point to a struggling bond market. Investors are demanding greater returns to lend to governments. For example, the US recently saw its 30-year bond yields reach 5.31% – the highest level since 2007. UK 10-year government bonds (known as gilts) recently breached 5% – a level not seen since 2008. As recently as 2020, 10-year gilts were as low as almost 0.1%, to give that number more perspective. There are similar comparisons one could make in the EU and Japan.

For governments, this is causing a headache. With many governments running deficits and holding debt-to-GDP ratios of close to or above 100%, small increases in yields can mean billions in extra costs just to keep the country running.

Why is this happening now?

Since the Covid pandemic, central banks have kept interest rates higher to combat increased inflationary pressures. Higher interest rates and rising inflation mean investors require higher yields to make buying bonds attractive. This has seen bond yields trend upwards for a few years.
More recently, this has been made worse by wider global political issues. The conflict in Iran has driven up oil and gas prices, adding to inflationary pressures. It was no coincidence a flare-up in violence in late August was followed by notable bond market swings.

With rising inflationary concerns, markets have watched for signs that interest rates might follow suit. When Federal Reserve chairman Kevin Warsh acknowledged concerns around stubborn inflation in late August, markets interpreted these statements as an indication a rate rise might be coming. As a result, global yields moved up.

On top of this, US government policy is pushing the world’s largest economy deeper into the red. US debt has more than doubled since 2016 and now stands above $40 trillion. It now spends more servicing the national debt than it does on defence. In this situation, some investors are beginning to question the sustainability of longer-term government bonds.

However, Greg Venizelos, Fixed Income Strategist at SJP, points out: “While there is lots of market talk about 'debt sustainability', it is important to remember the US can create the currency in which it services its debt, so it does not carry credit risk in the conventional sense (it cannot 'run out of money' like a company with debt can). The primary underlying risk is the potential for high levels of debt and persistent deficits to cause future inflationary problems.”

At the same time, the issues of supply and demand are rearing their heads. Tech companies are borrowing tens of billions of dollars to fund their AI build-outs. Combined with the increasing amount of government bonds being sold globally, investors can afford to be a bit pickier when it comes to placing their money. This is translating to upward pressure on yields.

Operation Twist

Governments have not been entirely passive on the issue. In August, the US Treasury launched ‘Operation Twist’ – buying back longer-term bonds with short-term bonds to reduce yields in the former. The idea was to push down yields on long-term bonds, which it did temporarily. By early September yields on 30-year Treasuries were almost back to their earlier highs though.

However, Greg suggests there is potential for more to come. He says: “There is certainly short-term noise in yield moves. The US 30-year bond yield has dropped below the 5.31% high that it hit on 17 August. At the time of writing, it was back at 5.29%. The intervention was indeed limited ($4 billion) and likely meant as a signal to the markets. The US Treasury General Account balance currently stands at $950 billion, ample dry powder that could be deployed towards further buybacks.”

Trump has also made no secret of his desire for the Federal Reserve to reduce interest rates in the past, though such a move seems unlikely with current inflationary pressures.

What rising yields mean for the UK government

The UK government is in a particularly delicate position. To stick to their own fiscal rules, the government only has limited spending powers currently.
Rising yields since the general election have meant that much of the previous fiscal headroom has been reduced thanks to extra bonds interest payments. And this will continue so long as yields remain high.

For chancellor John Healey, this presents something of a headache. To spur growth (and please the electorate), the UK government would ideally look to cut taxes or make spending commitments. Bond markets are pushing in the other direction. Any unfunded cut or initiative will likely see further pressure on yields. When Andy Burnham refused to rule out tax rises in the upcoming budget, he likely did so with half an eye on the recent bond market troubles.

The issue Burnham and Healey face is how to balance these contrasting needs. Further tax rises are likely to stifle economic growth and reduce spending. Unfunded tax cuts may help people struggling with inflation, but may be punished by higher yields, handicapping future budgets.

Mortgages and investments    

For the wider public, bond yields can have a notable impact on borrowing costs. In the US, for example, mortgage costs are closely linked to 30-year Treasury yields. For companies looking to borrow through bonds, higher yields will impact costs, potentially affecting their future ability to spend.

It’s not all bad though. Higher yields can lead to higher interest rates for savers, while also improving annuity rates for those looking to retire.

For investors, the current bond volatility adds an element of uncertainty to what is meant to be a defensive diversifier within a portfolio.

As a result, portfolio constructors need to be more thoughtful about where to invest. Greg adds: “Structurally, we prefer government bond exposure that has a defined maturity profile so we can manage risk in portfolios in a deliberate fashion. We have also taken material steps to diversify our fixed income exposure in recent times - adding significantly to inflation-linked bonds and also emerging market debt.”