The era of near-zero interests’ rates and negative rates in some parts of the world, such as Europe and Asia, orchestrated by central banks to stimulate economic growth post-financial crisis and during the pandemic, appears to be coming to a close. Recent developments, including 30-year US Treasury bond yields surging beyond 5% for the first time since 2007, are causing significant disruptions across various sectors, from housing to mergers and acquisitions.

The Risk of Financial Instability

Jim Reid, a strategist at Deutsche Bank AG, expresses concern about the abrupt shift in yields and its potential to trigger financial instability. He notes the contrast between the past decade and a half, characterized by authorities’ efforts to control yields, and the current environment where yields are rising, creating a risky situation.

The significance of US Treasuries in the global financial system underscores why this bond market movement matters. As the risk-free rate, all other investments are measured against Treasury yields. As these yields increase, their impact extends to various aspects of daily life, influencing areas such as car loans, overdrafts, public borrowing, and the cost of financing corporate takeovers.

The global debt load has reached staggering levels, with a record $307 trillion outstanding in the first half of 2023, according to the Institute of International Finance.

Key Factors Driving the Bond Market Shift

Several key factors are driving the dramatic shift in the bond market:

1. Stronger-than-expected economic performance, especially in the US, contributing to higher inflation levels.
2. The previous era of easy money has fueled inflation, leading central banks to raise interest rates beyond earlier expectations.
3. The notion of a quick reversal in monetary policy, known as the “pivot,” is losing credibility as recession fears diminish.
4. Governments issued substantial amounts of debt at low rates during the pandemic to support their economies, leading to concerns about unsustainable fiscal deficits, political turmoil, and credit rating downgrades.

These factors combined have pushed interest rates higher, impacting various aspects of the financial system and the economies they support. Some money-market funds and bank deposits are now offering a 5% yield. Yields on government bonds in countries like Germany and Japan are also on the rise.

Impacts Across Different Sectors:

Housing Market Challenges

For many consumers, the most noticeable impact of interest rate movements is in the housing market. Rising rates are leading to a surge in mortgage costs, affecting those who previously secured cheap deals during the pandemic. The UK, for example, is witnessing a drop in transactions and increasing defaults.

Government Finances Under Pressure

Higher interest rates increase borrowing costs for governments, adding to their financial burden. In the 11 months leading up to August, the interest bill on US government debt rose to $808 billion, up about $130 billion from the previous year. Prolonged elevated rates will continue to raise this bill, potentially necessitating more borrowing or spending cuts.

Stock Market Concerns

As US Treasury yields approach 5%, they become more attractive compared to riskier assets like stocks. The equity risk premium, a gauge of stock attractiveness, has reached its lowest level in over two decades. If the 10-year yield reaches 5%, it could trigger a broader sell-off in risk assets.

Corporate Squeeze

Many companies have relied on cheap borrowing in recent years. However, the era of “higher for longer” rates poses challenges for weaker firms with maturing debt. They may need to tap markets at significantly higher costs, potentially leading to cutbacks, job losses, and economic implications.

Deals Drought

Higher rates have deterred banks from supporting large mergers and acquisitions due to concerns about holding unsellable debt. This has led to a decline in leveraged buyouts, impacting global transaction values.

Real Estate Struggles

Commercial real estate, heavily reliant on borrowing, faces challenges as higher debt costs erode property valuations and increase loan-to-value ratios. This could lead to financial difficulties and property sales at lower prices.

Pension Pressures

Pension funds using a 60/40 investment strategy with bonds and stocks are facing challenges as both asset classes decline. Higher bond yields offer better returns for retirees, but steep rate increases can create unexpected problems, as seen in the UK last year.

Central Banks’ Stance

Central bankers are focused on slowing economies to combat high inflation. They are reluctant to rush to lower rates, even amid market turbulence. This steady approach suggests a commitment to their current course.

Johanna Kyrklund, co-head of investment at Schroder Investment Management, likens the bond market shift to the bursting of the dot-com bubble. She emphasizes the need for new investment strategies to adapt to the changing environment, as the last two years have reshaped market dynamics.