Spiralling chaos from the bond market will shake the world economy

DAVID MACNICOL & KEN REID
SPECIAL TO THE GLOBE AND MAIL

David MacNicol is president and portfolio manager and Ken Reid is a portfolio manager at MacNicol & Associates Asset Management.

The recent synchronized rise in global yields is not simply a U.S. fiscal ormonetary story.

Investors are reassessing global debt levels, persistent inflation and a changingworld order marked by geopolitical conflicts and trade disputes. Theseconcerns have increased bond market volatility and have begun affecting manybalanced-oriented portfolios.

As yields and bond prices move in inverse directions, sharp increases in yieldshave produced losses for many fixed-income investors, and that will likelycontinue.

Long-duration government yields have jumped to multidecade highs globally,especially across the developed world, with the U.S. 10-year treasury yieldmoving above 5.6 per cent, Japan’s 10-year yield near 3 per cent, and the British30-year yield above 6 per cent. Global long-term yields are signallingsomething beyond the typical response to central bank interest-rate increases:a lack of confidence from investors in the fiscal and monetary situation aroundthe world.

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Central banks now face a difficult task – balancing fragile economic growthwith elevated inflation. They are expected to be overly hawkish during thiscycle after getting it wrong during the last inflationary cycle, post-pandemic.

These central banks do not want to be wrong twice and will be fighting morethan inflation; they will be fighting the recent memory of having misread thesituation and investor confidence. However, keeping rates high for too longcould produce severe economic damage. If central banks maintain their hawkish stance, the bond sell-off could continue and expose deeper fiscalvulnerabilities across the developed world.

Governments are feeling the effect and consequences of higher yields. The U.S.Treasury recently tripled its bond buyback program from US$2-billion to US$6-billion. The Treasury claimed its decision was aimed at increasing liquidity inthe Treasury market. However, many investors are questioning the timing ofthe decision and have concluded the program is intended to minimize theincrease in interest rates.

The Treasury has also received political backlash for intervening in bond markets just a few weeks before U.S. midterm elections, as higher borrowing costs and affordability remain key issues for voters. Higher yields don’t onlyaffect consumers, but they also affect governments that are servicing massivedeficits.

As we have seen, this move by the Treasury has not decreased interest rates; ithas increased long-term rates and led to many investors questioning theindependence of the Treasury and its motives. Treasury Secretary Scott Bessenthas faced criticism, including from his former mentor Stanley Druckenmiller,over his handling of this situation. Druckenmiller, who famously shorted theBritish pound and “broke the Bank of England” in the 1990s, warned in anopinion piece last month that governments who defend prices againstfundamentals always lose, and the variable is how much they spend beforeconceding.

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Meanwhile, the U.S. Federal Reserve’s interest-rate policy has had ripplingeffects across global markets through currency movements, capital flows andimported inflation. Higher U.S. interest rates attract capital, support the U.S.dollar and place pressure on other currencies.

Central banks worldwide are feeling these pressures and are attempting toprotect domestic currency purchasing power, while avoiding further economicpressure from higher interest rates. Japan’s move away from ultra-low interest rates and consistent inflation worries in Europe could intensify global volatility in bond markets and could lead to further weakness.

For investors and consumers, higher benchmark rates mean higher borrowingcosts and lower bond prices. Many balanced portfolios that rely on fixedincome to cushion equity drawdowns have instead seen both asset classes fall,a repeat of 2022. The recent rise of yields has pushed bond prices down,affected investor sentiment and triggered credit-fund outflows.

Higher yields are not fundamentally negative: they can improve income for investors and normalize bond market pricing after years of near-zero yields.The danger today is not simply the level of yields, but the volatility and speed of bond-price adjustments, which are being intensified by fiscal vulnerabilities that adversely affect consumers, investors and governments.

Ultimately, global bond-market performance may not be entirely determined by monetary policy, and will likely be ascertained by investor sentiment toward inflation cyclicality and their belief in policy-makers’ control over it.Fiscal policy is expected be a driver of bond-market performance, as investors want governments to show their actions are sustainable and not volatile.

Global bond markets may remain unusually volatile as numerous parties navigate an uncertain economic environment.