Long-dated bond yields are rising, as investors start to price in a ‘higher for longer’ scenario. Is this a much-needed adjustment? Or the start of something more worrying?
- The UK and US 10 year bond yields have moved to their highest level since the start of 2008
- Higher yields have been fuelled by a combination of rising inflation expectations, higher borrowing and quantitative tightening. Weaker growth may help the UK and Eurozone economies deal with the problem.
Bond markets are spooked. The UK 10 year gilt yield has moved from 4.2% to 4.6%, its highest level since the start of 2008, while US 10 year treasuries are also at their highest level since the financial crisis. The ‘higher for longer’ narrative is taking hold and bond markets are being forced to revisit previous assumptions that rate cuts would start next year.
There are a number of factors at work. The first is recent US CPI data, which shows inflation is not beaten and is unlikely to follow a linear path lower. The chief culprit has been higher energy prices, but there remain concerns over the ongoing strength of labour markets and wage rises.
The second problem is rising government borrowing. Italy was forced to raise its deficit target for 2023 to 5.3% of GDP from 4.5%, and to 4.3% of GDP from 3.7% for 2024. It is not alone. In the UK, the cost of the national debt has reached a 20-year high. In each case, the financial authorities will have to find extra cash to meet spending commitments or face a difficult conversation with their electorates. This is raising bond issuance.
Quantitative tightening is also a problem as central banks try to unwind the vast holdings of government bonds built up during the post-Lehmans era. While they may pause these programmes if pressure on the bond markets becomes too acute, it has created a glut of bonds on the market that has contributed to rising yields.
This is a real problem for over-indebted governments, whose borrowing costs are spiralling. In Europe and the UK, it is coming at a time of weak economic growth, which may create more spending demands. It is also a problem for economic growth, feeding into mortgage rates and corporate borrowing costs. When there has been this type of turmoil in bond markets, it has seldom ended well for equity markets.
Nevertheless, the news may not be universally gloomy. Core inflation – which excludes volatile food and energy prices – continues to drop. This is likely to be more of a factor in central bank decision-making. While they will continue to talk tough on inflation, they may be more willing to overlook these factors when setting rates. Equally, the picture is very different for the UK and Eurozone than for the US. Economies across Europe are noticeably slowing, which should give central banks there more flexibility to cut rates. It is the US where pressures are greatest.
In reality, ‘higher for longer’ was the risk for which markets were unprepared. The rising bond yields seen over the past week may just be a simple adjustment and could end here. Investors may not need to panic just yet.
