Bond yields continue to rise. US 10 year Treasuries are now close to 5%, UK 30 year gilts just under 6%. But, the real problem is what is causing yields to increase. Oil has gone back above $100. And diesel prices are hitting records in the US.
Last week the US Treasury Secretary, Scott Bessent, dared traders to bet against him. He was talking about the yen, which he has been spending American money to prop up. “I’m the house now,” he said. “And you can bet against me if you want.” But, this Yen intervention is of course driven by bond market. It is no outbreak of altruism, only a fear if Yen slides, the Japanese will sell their US Treasuries. So far, nobody has really taken his bet on the yen. But they’ve been taking it on the bond market, all the same.
Bessent, of all people, should know how this goes. In 1992 he was working for George Soros, when Soros broke the Bank of England’s defence of the pound. Governments can try to hold the line in one market. They can’t hold it everywhere. You can read about that fascinating story (ERM Fiasco) here.
To give some perspective on rising yields. In 1981 yields hit 15%+. Against that, 5% looks modest, and it could mean there is room to rise further. But debt is far higher now and growth is far lower. Which means 5% today could hurt almost as much as 15% did then.
So how worried should we be?
Currently we are experiencing both a rise in oil prices and bond yields at the same time. The sell-off in bonds last week was mostly in response to further disruption in oil supplies in the middle east. With Hormuz blocked, the East-West pipeline is a vital alternative, but now it has been struck by Houthi rebels. And Bab-el-Mandeb is becoming another chokepoint. But this comes at a time of falling oil inventories and a real shortage of diesel and jet fuel. For motorists, the pain is already here, with diesel prices hitting a nominal record in the US. The UK now has to face both rising oil and gas prices, which will push up household bills. And with recent growth stronger than expected, it is more likely the Bank of England will now raise rates.
But the rise in bond yields is definitely a global phenomenon. As you can see all countries are experiencing a rise in bond yields, but there is a difference. As Robin Brooks points out, countries with higher debt levels are seeing a faster rise in bond yields. And the rise is bigger for long-dated 30 year bond yields. Basically, at least part of the reason for rising yields are fiscal concerns over the market. This is disputed, Paul Krugman argues the rise in bond yields is not linked to fiscal dysfunction, there is nothing special about say rise in long-term US bond yields. For example, they were higher in the late 1990s, despite lower inflation and a budget surplus.
And this is what might break first — Government spending plans. US debt interest payments as a share of GDP are now exceeding levels of 1991. But, unlike then, economies face a structural increase in borrowing due to lower growth and higher debt. Debt interest payments are growing faster than the rate of economic growth. But look at projection for US debt over the coming years. This is why a rise in bond yields, could break government’s ability to pay for social security.
And you can see already UK debt interest payments are higher than defence and pretty much equal to the education budget. Governments borrowed on the premise yields would stay low, they haven’t planned for this rise in yields. If interest rate costs rise further, you have to take it from elsewhere.
AI Bubble and Private Bond market
Rising bond yields isn’t just about government debt, it is also about an AI boom or if you prefer AI bubble. There has been a sharp rise in private investment in IT, and this is now being financed by borrowing on corporate bond markets.
J.P. Morgan found six AI companies are borrowing $320bn via the bond market, equivalent to 68% of new long-duration US Treasury borrowing. This surge in private borrowing is causing interest rate spreads on AI investment to rise. But, importantly creating competition for government bonds, pushing up bond yields.
So are we losing control of the bond market?
Well to give a historical context this graph shows the Golden Rule that Treasury yields should equal the moving 10 year average for nominal growth. So when inflation leads to higher nominal growth, bond yields rise. This suggests that bond yields are exactly where they should be.
But, what happens if governments need to spend more on defence, pensions and health care, but interest rate costs make it impossible? One option is to create currency and buy back their own debt. Just like the US has done in a limited way in recent weeks. This raises scope for debt to be inflated away, causing bond holders to lose.
Look at the mid 1970s, yields were kept lower than nominal GDP growth, bond holders lost out, government reduced the debt burden through inflation, a hidden tax on bond holders. At what point, do governments have the temptation to try the same solution?
Pensions
It’s not just the government, when bond yields rise, bond prices fall. A 1% rise in yields cuts the price of a 10 year gilt by 7% and a 30 year gilt by 13%. This fall in bond prices can reduce the value of your pension. Remember when UK yields spiked in 2022, pension funds came under severe strain as the value of their bond holdings collapsed, forcing the Bank of England to intervene. Now the impact is less rapid but coming in the same direction. The only caveat, is that if you want to invest in high yielding assets, the rise in bond yields is good for those savers.
Housing
A more direct impact is to housing costs. US 30 year mortgage rates are closely linked to 10 year bond yields. But Mortgage rates are rising at a time of much higher real house prices. It is causing a frozen market, and risk of house price slide. In the UK, mortgage rates have not risen by as much as the US because mortgage rates are more linked to Bank of England base rates, but rates could rise further in the coming months. And don’t forget some who got a 5 year fixed rate mortgage at 1.3% in 2021 will now be facing big jump in mortgage costs. For example, a £200,000 mortgage remortgaging to 5.66% could be an extra £470 a month.
Already house prices have slid in the past few years, at least in real terms. Recent news puts more upward pressure on interest rates and risks a further slide in real house prices.
Do rising bond yields end in recession?
This graph shows correlation between bond yields and recession. The years of recession are shaded in grey. Since the 1960s, rising bond yields have often occurred during recessions like in the 1970s, or in recent decades a recession has occurred a year and a half after the bond peak.
But the current situation is more reminiscent of the 1970s because the stand out feature is a confluence of problems at once, rising yields and inflationary pressures. The problem is not really bond yields, but what is causing it.
Now, it is worth pointing out another perspective. Bond yields are rising due to both short-term inflation, AI bubble and longer-term fiscal issues. But, if rising interest rates were to push the economy into an economic slowdown and recession, you would probably see bond yields come down. There is a self-correcting mechanism. Equally, the AI bubble does seem unsustainable, even the tech bros are looking for an off-ramp for levels of investment. If the AI bubble burst, again you would see yields come down.
Historically yields rise until something breaks, the breaking point is lower now because debt is higher. At least in the short-term rising yields, will cause real economic pain, especially for the governments who have to pay higher debt interest payments. The big question is what happens next, will advanced economies be tempted to allow inflation to rise, rather than hike interest rates to slow down the economy. Central Bankers have lot of difficult decisions in the coming months.
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