Why cracks are widening in financial markets
There’s a rapid shift under way in the global cost of capital, with yields in the world’s key bond market soaring overnight.
The US bond market provides the reference points for global debt, and developments in that market are undermining the finances of governments worldwide, while adding to the pressure on companies and households.
Yields in the US Treasuries market have been edging up all year, driven by rising US government deficits and debt and an inflation rate kept stubbornly high by Donald Trump’s war in the Middle East, his trade wars and the boom in artificial intelligence-related investment.
On Wednesday in the US, the day started badly for the market when there was a sell-off in European bonds in response to another surge above $US100 a barrel in oil prices, after Iran responded to Trump’s threat at the United Nations to “annihilate” the country by saying it wouldn’t relinquish control of the Strait of Hormuz unless and until the US lifted its sanctions.
The oil price, which was below $US100 a barrel on Tuesday, is now trading around $US103 a barrel.
The selloff accelerated after the mid-morning release of the S&P Global flash US Composite PMI (purchasing managers) Output Index, which showed an unexpected jump in manufacturing and service sector activity, as well as a surge in the prices of business inputs.
Then, at 1pm (New York time), a $US70 billion auction of five-year Treasury notes experienced weak demand, selling at a yield well above traders’ expectations. “Primary dealers” – those who are forced buyers at auctions – ended up with unusually large allocations.
Even the announcement by US Treasury Secretary, Scott Bessent, of a $US6 billion bond buyback couldn’t avert the flood of selling. Bessent’s transparent attempt to manipulate and cap bond yields was destined to fail – and has failed.
The yield on the benchmark 10-year bonds jumped from 4.96 per cent to as much as 5.13 per cent – its highest level since 2007, ahead of the global financial crisis. In February, before the war in the Middle East started, that yield was 3.94 per cent.
Across the yield curve, the yields rose while, in the sharemarket, equity indices – which have, thanks to the AI stocks, been at record levels – fell. The S&P 500 was down 0.8 per cent and the Nasdaq index 1.1 per cent.
If the US Federal Reserve Board’s 25 basis point increase in its policy rate – its first-rate rise in more than three years – didn’t signal it, the decisive move above 5 per cent by the 10-year bond yield says the US has entered a new, higher-rate environment.
With the futures market now pricing the odds of another Fed rate hike next month – just ahead of the midterm elections in the US – at about 70 per cent, with more rate rises to come next year, the US has entered a new rate-raising cycle.
While the combination of better-than-expected growth – the OECD has forecast developed economy-leading 2.2 per cent growth in US GDP for this year – and stubbornly high inflation is peculiar to the US, the turmoil in its bond market, and the factors driving it, aren’t.
There are similar spikes in yields occurring in most of the major markets. While the rising US yields might be having some influence on global yields, the more significant correlations relate to historically high, and unsustainable, levels of governments’ deficits and debt.
In the US, the deficit is pushing $US2 trillion, or 6 per cent of GDP, this year, while gross federal government debt is above $US40 trillion and the net debt-to GDP ratio is just under 100 per cent. Large parts of Europe have similar, if not worse, metrics, so it isn’t surprising that yields in the eurozone have also spiked.
Trump’s trade and real wars haven’t helped. The movement in the 10-year bond yield on Wednesday was the biggest one-day rise since Trump unveiled his “Liberation Day” tariffs in April last year.
His tariffs, and the impact of the war in the Middle East on oil, and therefore petrol and diesel prices, have driven inflation and interest rates up and growth down in most of the developed world, with US growth sheltered by the AI-driven investment boom.
That, too, is driving costs and inflation up and, by adding to the supply of debt and competing with government bonds for investors’ funds, is also adding to the pressure on US bond prices, which fall as yields rise.
Since the 2008 financial crisis, the US and other major economies have operated generally within a low-rate environment and one that, until the post-pandemic disruption to global supply chains, was also one of low inflation.
By historical standards a 5 per cent 10-year bond yield isn’t abnormal – the post-war average is around 4.7 per cent. Since the financial crisis, however, the yield has averaged about 2.8 per cent, so the current pricing regime is one that most people and businesses haven’t experienced in a generation.
There may be more to come. There’s no obvious end in sight to the war in the Middle East and the impact of high transport fuel costs, and Trump’s tariffs, are still seeping into the wider economy and the cost of goods.
There’s also no sign of any enthusiasm by either the Republicans or Democrats, or their counterparts in parliaments around the developed world, to even start to take the painful decisions required to stabilise ballooning deficit and debt levels, let alone start to reduce them.
While the combination of better-than-expected growth … and stubbornly high inflation is peculiar to the US, the turmoil in its bond market, and the factors driving it, aren’t.
A particular problem facing the US is that those who were large and long-term buyers and holders of its debt in the past are deserting it.
Foreign governments – particularly China, which has more than halved its Treasury holdings from their peak in 2013 – have been reducing their exposure to the US, replaced at the margin by hedge funds and retail investors.
Some of that reduced interest can be attributed to the shock generated when Russia’s foreign exchange reserves were frozen after its invasion of Ukraine in 2022, as well as to the way the US has used its dominance of the global financial system to slap sanctions on its perceived foes. There has been a surge in central bank buying of gold in response.
It also relates to the rate at which the US Treasury has been issuing new debt, which is outpacing the growth rate of sovereign reserves in the rest of the world.
Whatever the reasons, long-term passive investors have been replaced by shorter term and more leveraged traders that are probably more willing to dump their holdings in response to shifts in the perceived risks.
That could be adding to the more volatile conditions in the bond market and the upward pressure on yields in what is, in the Trump era, a period of heightened financial and geopolitical risks.
The ever-increasing debt load, Trump’s aggressive treatment of America’s long-term allies and his erratic (and commonly self-destructive) policies are remaking the US bond market into something other than the world’s safe haven that it has been in the post-war period, at a moment when the global economy and financial markets are as leveraged and vulnerable as they’ve ever been.
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