The global bond market is experiencing significant turbulence as a wave of selling has gripped markets around the world, leading to a rapid increase in yieldsInvestors are asking why this is occurring amid looming interest rate cuts by the Federal Reserve.
On Wednesday, the yield on the U.S10-year Treasury bond temporarily surged to 4.73%, nearing the 5% peak reached in October 2023 before retreating somewhatMore alarmingly, the 20-year Treasury yield has already breached the 5% mark, while the 30-year bonds are hovering around 4.96%. This scenario closely resembles the market dynamics witnessed earlier in 2023 when the U.S
stock market fell significantly.
Analysts have pointed out that the stock market may face further declines in the upcoming months, a prediction that raises concerns about the overall stability of risk assets amid this renewed volatility.
Bank of America suggested that if Treasury yields surpass the 5% threshold, it may prompt investors to reassess the valuations of risk assets, ultimately leading to pressure on the stock market.
At this juncture, one question arises: the Federal Reserve is in a cycle of interest rate cuts, yet Treasury yields are soaring
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What is the market signaling?
Simply put, concerns over inflation have led traders to reduce expectations for interest rate cuts from both the Federal Reserve and the Bank of England this year.
For example, soon-to-be former Secretary of the Treasury Janet Yellen has indicated that pandemic-related spending could have a "mild" inflationary effect, with an unexpectedly robust economy leading to a recalibration of market interest rate expectationsThis has fueled the recent Treasury sell-off.
Moreover, the market is currently evaluating the potential impacts of tariffs that the newly elected President of the United States might implement, contributing to rising global bond yields.
On January 8th, economist Paul Krugman published an article noting that even as the Federal Reserve begins to cut rates, long-term interest rates—such as those for 5-year auto loans, 10-year corporate bonds, and 15- or 30-year mortgage rates—are rising in contrast to movements in short-term rates, such as the Fed fund rate; this phenomenon is unprecedented.
Krugman suggested that the rise in longer-term rates, like the yield on the 10-year Treasury bond, could reflect a frightening, insidious skepticism—that investors may actually start to believe the outlandish proposals of economic policies he has discussed, and that these might be enacted.
According to Krugman, the bond market’s reactions indicate that investors are beginning to foresee the inflationary pressures that such policies could bring, thus altering their expectations for future Federal Reserve actions:
If any major elements of these proposals are indeed implemented, the Federal Reserve would clearly have to halt any further rate cutsIn fact, the Fed might find it necessary to raise rates again.
Yet, given the potential pressure for the Fed to continue cutting rates, Krugman argues that if the Federal Reserve ultimately succumbs to this pressure, it would only mean a further increase in interest rates, not a decrease.
Countless economics students are aware of the predicament Richard Nixon faced in 1972, where he forced the Federal Reserve to keep interest rates low despite worsening inflation problems
This ultimately led to a profound surge in both inflation and interest rates.
Krugman offered two possible explanations:
The first one is that stock investors and bond investors are not the same; the former are more emotional and susceptible to sentiment factorsEveryone is familiar with the phenomenon of meme stocks, which are driven skyward thanks to the fervor of social mediaHowever, as for meme bonds, I have yet to hear of them.
The second explanation is that the recent uptick in the stock market is relatively shallow. It can be argued that this is mainly attributed to the influence of artificial intelligenceThe Dow Jones Industrial Average serves as a representation of the non-AI economy, which has almost nullified the effects of these gains.The last time U.STreasuries fell this dramatically, the stock market crashed as well.
In October 2023, the yield on the 10-year Treasury bond almost approached the 5% mark, resulting in a substantial pullback in the U.S
stock market.
However, during the current round of rising bond yields, the stock market only experienced minor adjustments, which may imply that if yields continue to increase, the stock market could face further declines.
Goldman Sachs strategist Christian Mueller-Glissmann and others stated in a recent report that the correlation between stock and bond yields has turned negative again; should bond yields continue to rise amidst disappointing economic data, this would pose a significant impact on the stock market.
The report concluded:
“Considering that the stock market has been relatively stable during the bond sell-off, we believe that in the event of negative economic news, the risk of a correction for the stock market may indeed increase in the short term.”Recently, Morgan Stanley's chief strategist Michael Wilson also warned that as the yield on the 10-year Treasury rises to over 4.5%, it is putting pressure on U.S
stock valuationsThe correlation between the S&P 500 index and bond yields has turned “significantly negative,” forecasting severe challenges for the U.Sstock market in the next six months.
Goldman Sachs also added that current long-term U.Sdebt rates are rising sharply, with a steepening yield curve reflecting market worries about U.Sfiscal and inflation risks, and importantly, the changes are occurring mostly in real yields, which strip out inflation factors.
Markets have already readjusted their rate cut expectations, anticipating that by July, the Fed may only implement one 25 basis points rate cut, while maintaining a firm belief that the U.S
economy can achieve a “Goldilocks” scenario, where economic growth continues alongside low unemployment and manageable inflation risks.
Yellen: "I do not want to see the return of the bond vigilantes."
In a CNBC interview on Wednesday, January 7th, Yellen expressed her hope that the incoming administration would take the U.Sfiscal deficit seriously, highlighting that the Treasury market should not suffer from the kind of retribution seen from the “bond vigilantes” decades ago.
The term “bond vigilantes” was first introduced by Wall Street analyst Ed Yardeni in the 1980s, referring to investors who pressure governments and central banks to change policy by lowering bond prices and raising yields.
Yellen stated, “I don't want to see a scenario where the bond vigilantes come out; global investors expect the U.S