The bond market has crashed in the fight against inflation

At this time the return on 10-year bonds is 3.35%, having started the year at 1.5%. It is conceivable that those bonds will yield just over 4 percent for the first half of next year. Two-year US Treasuries are yielding 3.5%, their highest level since 2007.

It’s not just government bonds whose yields are soaring. Funds that invest in high-yield debt (often referred to as “junk bonds”) are experiencing massive outflows as spreads between yields on the sub-investment-grade debt in which they are invested and those on bonds in the government have skyrocketed and generated double-digit gains. losses for investors in the funds.

The Reserve Bank raised its cash rate by 50 basis points this week, the fifth increase in five months.Credit:Louis Douvis

Junk bond yields started the year around 4.3 percent but have since soared to more than 8.5 percent, with the spread over 10-year government bonds widening by about 3 percentage points. to more than five percentage points.

The rise in interest rates around the world has also almost ended one of the most peculiar developments in financial markets in the last decade.

As European and Japanese central bank policy rates plunged into negative territory after the 2008 financial crisis, a massive stock of negative-yielding debt emerged. Even some European companies were able to attract investors willing to pay for the privilege of owning their debt.

The amount of negative-yielding debt peaked at $18.4 trillion at the end of 2020, in response to extraordinary measures central banks took in response to the pandemic but, as interest rates rose rapidly this year , the stock of that debt was reduced. at insignificant levels.


The income losses embodied in those bonds from negative yields would now be compounded by the principal losses generated from higher yields in the market.

In hindsight, it is clear that investors underestimated the resolve of the Fed and, more recently, that of their peers, as they have faced the highest inflation rates in decades. The US inflation rate is 8.5 percent, the eurozone’s 9.1 percent and Australia’s 6.1 percent, its highest level in three decades, and rising.

In fact, US yields were beginning to ease slightly until Fed Chairman Jerome Powell delivered his ultra-aggressive speech at the Jackson Hole conference in Wyoming late last month. The stock market instantly tanked and bond yields began to rise again as the implication of his comments about the pace and duration of this rate hike cycle sank.

The change in the monetary policies of the major banks represents one of the largest and most abrupt tightening of monetary policies since the 1970s, with the speed at which rates have been rising and the impact of the constant withdrawal of liquidity as The Federal Reserve reduces its balance sheet. (by not reinvesting the profits from the maturing securities it bought during its various post-GFC QE bouts) clearly taking stock and bond investors by surprise.

Today there is nowhere to hide, with all major financial markets deflated and awash in red ink as belated but increasingly aggressive efforts by central banks to control inflation continue.

How that will play out in a world that, post-pandemic, is awash in debt is the multi-billion dollar question.

While businesses and households in the major developed economies appear to be in relatively good shape, there are generations that have never experienced inflation rates at these levels or interest rates that have risen so rapidly and steeply, with a long way to go before to reach its peak.

Emerging economies and Europe are being hit by the combination of rising rates and a stronger US dollar, driving up the cost of mining and agricultural raw materials, as well as the cost of servicing and repaying US dollar-denominated debt. .


There is also, of course, an energy crisis in Europe and elsewhere, caused by Russia’s invasion of Ukraine and Western sanctions and Russia’s responses to them, adding to global inflation rates and pressure on businesses and households.

For investors, bond markets used to be the safe haven in turbulent times for riskier markets such as equity markets. Today there is nowhere to hide, with all major financial markets deflated and awash in red ink as belated but increasingly aggressive efforts by central banks to control inflation continue.

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