A recent analysis by strategists at Bank of America reveals an alarming statistic – the US bond market has suffered its longest period of losses in 236 years.
While record-keeping may have been sparse in the nation’s early decades, the magnitude of the losses highlights the immense pain rippling through finance in the wake of soaring inflation and interest rates.
This pain has already claimed Silicon Valley Bank and three other regional lenders this year, pushing others into crisis until policymakers intervened.
The angst is rapidly mounting on Wall Street about the precarious state of US finances. Massive deficits from Republican tax cuts and Democratic green energy investments seemed harmless when the Federal Reserve kept rates at zero and purchased bonds by the tens of billions each week.
But with rates now at 5%, the math looks troubling. The government’s costs and borrowing needs are swelling so fast they risk overwhelming demand for Treasuries, long seen as the world’s safest investment. “There’s just way too much debt,” says economist Ed Yardeni, founder of Yardeni Research.
While the US is not at risk of defaulting on its debts, the recent debt ceiling brinkmanship in Washington raises concerns. The real worry is that surging yields will squeeze companies and consumers so tightly something in the economy snaps, potentially triggering a painful recession.
“We’re getting pretty close to the level where something could break,” warns Yardeni, pinpointing 5% on the 10-year Treasury as the danger zone. Last week, it reached 4.89%, up from 4% two months prior and 0.3% during the pandemic.
The bond sell-off has already broken records. Losses reached almost 50%, echoing the dot-com stock bust. At one point last quarter, the yield spike was the sharpest since the 1987 crash.
The pain has spilled into stocks and corporate bonds while propelling the dollar’s rally against most currencies. Even oil got sucked into the vortex last week, snapping a months-long rally.
This shocks Wall Street veterans who grew accustomed to the Fed-engineered stability in recent years. With growth and inflation low after the 2008 crisis, rock-bottom rates became the “new normal.”
Few saw anything disrupting this, even amid massive pandemic stimulus spending. But change has arrived at a dizzying pace, with experts citing forces like climate change, deglobalization and demographics that could keep yields elevated for years. “We are in a world with a permanently higher cost of capital, and that does have consequences,” says Apollo Global Management’s Torsten Slok.
The easy money era from 2008-2020 now looks abnormal, even though it came to seem normal. The Bank of America analysis found global rates lower than anytime in 5,000 years. “The new world that we live in is really the normal world that we were in,” says Slok.
It’s a world where bond traders have an outsized voice, the Fed’s is diminished, and consumers, companies and lawmakers must reckon with the end of free money.
Yardeni’s “bond vigilantes” have returned to their traditional role – pushing yields up to send a warning to Washington about inflation and deficits. While the US won’t default, the higher borrowing costs squeeze households and businesses. Push rates up too quickly, Yardeni warns, and something will break, potentially triggering a recession.
This is a far cry from the comatose bond market of recent years, where yields hovered around 2% endlessly. That reliability lulled companies into complacency about risk and borrowing costs. Executives greenlit projects assuming cheap capital would always be ample. Lawmakers passed sweeping reforms with little worry about swelling deficits.
But the free money experiment has ended, and the hangover has begun. Borrowing costs are jumping for governments, companies and consumers alike. Corporate investment plans predicated on low rates are being revisited or scrapped altogether.
Money losing tech companies are laying off workers and shelving expansion hopes. Across the economy, there is a reckoning underway about what constitutes prudent financial planning and risk management in this new era of higher rates.
Meanwhile, Washington faces renewed urgency about fiscal restraint. While deficits may have seemed harmless when financed with Fed-supplied easy money, that option is off the table for now.
As higher rates drive up the government’s financing costs exponentially, it heightens the need to curtail spending and borrowing. Otherwise, the bond vigilantes will demand even higher yields, threatening to break something in the strained economy.
For policymakers, companies and investors conditioned to the easy money era, this transition is jarring. But it represents a return to normalcy as the economy comes off emergency stimulus and extraordinary central bank support. Free money allowed a disconnect between economic realities and financial markets.
As that cushion is removed, traditional relationships are reasserting themselves. Borrowing costs rise with deficits and inflation. Risk-free returns disappear. Prices fall for bonds, crypto and unprofitable tech stocks.
While painful, these market corrections represent the pendulum swinging back from distortions created by a decade of free money. Asset values are resetting lower as the safety net is removed.Risk premiums are returning.
Inflation fighting has replaced stimulus as the policy priority. For market participants, it’s a stark departure from the tranquil, predictable environment they had come to expect. But it’s a return to the way markets are supposed to function.
With free money behind them, companies, individuals and governments alike will need to adjust to this new-yet-old reality of living in a world with a normally high cost of capital.