The surge in bond yields is the principal focus of financial markets
- The rise in bond yields continued last week, with the yield on the US Treasury’s 10-year bond hitting a three-year high of 4.82% before retreating to 4.75% later in the week, after new comments from a Federal Reserve governor (discussed in later sections).
Prior to this, the yield had not been higher since 2023. Meanwhile, the yield on the 30-year bond hit the highest level since 2007. To date, the US Treasury’s effort to influence long-term yields through market intervention has not had a sustained impact, which suggests that intervention without changes in market fundamentals may sometimes have unintended market reactions.
It might convince some traders that things are worse than expected. The latest incident in the Strait of Hormuz appears to have reinforced concerns that the crisis could persist, potentially leading to higher inflation. Futures markets now show an implied 68% probability that the Fed will raise the benchmark interest rate in September.
In the United Kingdom, the yield on the 10-year gilt hit 5.2%—the highest since June 2008—likely reflecting a view that inflation will accelerate. Moreover, futures markets are now pricing in a 70% probability that the Bank of England will hike the benchmark interest rate in November. With memories of the tenure of Liz Truss hanging over new Prime Minister Andy Burnham, the Chancellor of the Exchequer John Healey will present a budget in October. The new government must navigate a difficult path, attempting to appease bond investors while pleasing voters with favored spending programs.
If bond investors interpret the budget as not addressing fiscal issues, bond yields could rise sharply. The government cannot afford such an outcome, given Britain’s borrowing costs already exceed those of the United States, Germany, and France.
Meanwhile, in Germany, the yield on the 10-year bond hit 3.36%—the highest since April 2011. The yield in France hit the highest since 2008, and yields in Italy and Spain hit their highest levels in three years. Investors generally expect the European Central Bank to raise its benchmark rate in September. Futures markets now show an 80% probability of another rate hike in December.
In Japan, the yield on the10-year government bond briefly surpassed 3% for the first time in three decades. While the latest surge may partially reflect the potential inflationary impact of events in the Middle East, traders are also focused on Japanese fiscal policy as well as interest differentials with the United States. Yields also increased in other East Asian countries.
All of this raises an important question: Are higher yields a bad thing? And, as in many other aspects of life, the answer is: It depends.
Bond yields generally move to bring supply and demand for loanable funds into balance. If demand for funding rises in relation to supply, yields will often tend to rise, and vice versa. If the performance of an economy improves, leading to greater profitable investment opportunities, the equilibrium yield could rise, which would not necessarily be a bad thing. If, however, demand for funds rises relative to supply because of a lack of fiscal probity, yields may rise, potentially stifling private sector credit activity. Or, if expectations of inflation rise and investors require protection from the risk of inflation, yields may also rise and that won’t be a good thing.
Consider the period between the global financial crisis (2008 to 2010) and the COVID-19 pandemic (2020 to 2021): This period was characterized by historically low inflation and historically low bond yields. Some economists suggested that, in part, the low yields reflected an excess supply of savings in the world relative to investment opportunities. It might have been related to weakness in aggregate demand in the global economy.
Now, fast forward to the current situation: We have higher expectations of inflation, which may partly explain the rise in yields. And we have historically large budget deficits in several major countries, which may also explain such high bond yields. But we also have a new, revolutionary technology that has led to massive growth in investment. It has led to expectations of strong productivity growth and potentially faster economic growth. These, too, might partly explain the rise in bond yields. In that sense, higher bond yields could be seen as reflecting a better economic picture.
Indeed, yields that are too low can lead to poor capital allocation. If yields are closer to zero, there is effectively no opportunity cost associated with making bad investments. A high yield can have a disciplining effect on capital markets, likely directing capital toward the most potentially profitable use cases.
Consider the case of Japan which, until recently, had yields near or below zero. It also had a prolonged period of suboptimal growth. Yet now, the yield on the government’s 10-year bond is around 3%—the highest since the mid-1990s. Some analysts suggest that this is a sign of economic health, and could mean that the country has many favorable investment opportunities, and that Japan could soon return to a sustained higher rate of growth.
On the other hand, Japan faces higher-than-desired inflation. In addition, it faces a potentially disruptive level of government debt. These factors partly explain higher yields. And Japanese yields have suddenly risen sharply, which was probably not just due to a sudden improvement in economic prospects. As such, it remains unclear whether Japan’s economy is capable of supporting the 3% yield. In any event, at the very least, the high yields will likely mean that capital will only flow to the best opportunities.
One factor that has lately contributed to higher yields is the rise in energy prices. Last week, the price of Brent crude went as high as US$97 per barrel before somewhat retreating. Just a week earlier, the price was under US$88 per barrel. The sharp rise appears to be related in part to the conflict between Iran and the United States. During the week, there has been a return to hostilities between the two countries. Moreover, there does not appear to be any movement toward a resolution, either. If higher prices are sustained, they could add to inflationary pressures around the world.
Meanwhile, the price of European natural gas has increased sharply—hitting the highest level since early 2023. In just the past month, the price has risen roughly 40%. About 20% of globally traded liquified natural gas travels through the Strait of Hormuz, mostly coming from Qatar, and much of it goes to Europe. This route has been disrupted. Plus, the winter season is approaching while European gas reserves are at a level below normal. The latest inflation data from the European Union showed acceleration, thereby boosting the likelihood of further tightening of monetary policy by the central bank.
Finally, as mentioned above, US yields temporarily fell last week after Federal Reserve Governor Christopher Waller spoke about the future trajectory of monetary policy. Specifically, Waller said that he “would be inclined to support holding the target for the federal funds rate at its current setting.” He said that his decision at the upcoming meeting this month will be determined by data. Specifically, he said that “if there is continued progress toward our 2% goal, then I am willing to support holding the policy rate at its current level. But if inflation comes in hot, I would consider a rate hike.” Following Waller’s comments, the future market’s implied probability of a rate hike this month dropped from 63.2% to 50.3%.
The comments from Waller, which follow comments by New York Federal Reserve Bank President John Williams suggesting that inflation is being tamed, led not only to a drop in US bond yields but also a decline in the value of the US dollar.
The global selloff of government bonds appears to reflect multiple risks in the global financial system. These include expectations of higher inflation, expectations of tighter monetary policy, concern about fiscal policy in multiple countries, and concern about the massive issuance of bonds by tech companies.
Yet, equity investors appear to be largely focused on artificial intelligence than on those risks. The performance of equity prices likely reflects the view that, despite short-term headwinds and risks, massive investment in AI could generate sizable positive returns in the near future.