Bond vigilantes are making their presence felt again, and equity markets are starting to feel the impact.
The cost of 30-year US government borrowing has climbed to levels not seen since 2007, sending stocks lower for a third consecutive session and prompting investors to reassess risk across markets.
Bond vigilantes never really disappeared; they simply went quiet for a period. Now, signs suggest they are becoming active again.
As I was quoted by CNN, Reuters, Yahoo Finance, Investing.com, Barron’s, London Loves Business, Finance News Network, and Investor Ideas, among other media, long-term Treasury yields have remained above 5% for much of the past month, while oil has climbed above $85 amid Middle East tensions and inflation has stayed above target for five consecutive years.
Together, those factors are creating the conditions for bond investors to demand higher returns.
Why Bond Vigilantes Are Demanding Higher Yields
The 30-year Treasury yield has spent more trading sessions above 5% this year than in any year since 2007. In 2007, it remained above that threshold for 50 sessions.
The US Treasury market has expanded dramatically, from around $4.5 trillion in 2007 to more than $31 trillion today. Federal debt has risen above 100% of GDP. Interest costs have now surpassed $1 trillion for the first time.
In addition, UK gilts could emerge as the weakest link in an escalating global bond sell-off. This year, ten-year gilt yields have climbed above 5% twice. They did so amid the same Iran-related tensions, reaching an 18-year high on both occasions. Meanwhile, the 30-year gilt yield hit its highest level since 1998 just months ago.
The UK has structural vulnerabilities that set it apart from many of its peers.
Public sector debt is now close to 95% of GDP. It is almost three times its pre-financial-crisis level. Annual debt-interest costs have climbed above £100 billion, representing one of the UK’s debt-servicing burdens in the past 50 years.
The UK has only a few billion pounds of fiscal headroom. Its debt burden runs into the trillions, leaving little room for manoeuvre. If a bond-market shock of this scale intensifies, the government has limited options.
In the US, however, with the government spending more than $1 trillion each year simply servicing its debt and more long-term borrowing still ahead, bond investors have greater leverage to demand higher yields and dictate the terms of financing.
Investors are increasingly unwilling to assume that government spending will be brought under control. Instead, markets are beginning to price in the risk that fiscal pressures could persist.
Oil and Inflation Add Pressure to Bond Markets
Renewed tensions around the Strait of Hormuz and a lack of progress towards a potential US-Iran agreement have driven oil prices higher, reigniting inflation concerns just as traders were scaling back expectations for further interest-rate cuts.
The surge in oil prices could hardly come at a worse time for bond markets.
Every additional dollar added to crude prices strengthens the case for persistent inflation, making it more difficult for the Federal Reserve to justify further rate cuts while giving bond vigilantes more reason to demand higher yields.
If the central bank attempts to ease policy while inflation remains stubbornly elevated, it risks undermining its credibility with government bond investors. Once that confidence starts to erode, yields can shift away from reflecting growth expectations and increasingly reflect the higher compensation investors demand for taking on risk.
Furthermore, a surge in corporate borrowing to finance artificial intelligence infrastructure is another source of pressure on the government bond market.
Government debt is not the only long-term debt flooding markets. Large technology companies are increasingly raising funds for AI infrastructure, competing with governments for the same pool of bond investors at a time when sovereign borrowers need that demand most.
When two major groups of borrowers compete for limited investor capital, the cost of attracting buyers rises for everyone.
What Higher Bond Yields Mean for Investors
What happens next if bond yields continue to rise?
First, equity valuations based on low discount rates come under increasing pressure, with the most expensive and speculative areas of the market likely to feel the impact first.
Second, governments face a difficult choice between tightening fiscal policy and accepting significantly higher borrowing costs. Bond markets may keep testing which path policymakers take.
Third, currencies and emerging markets could bear the brunt of the spillover, as investors shift capital towards whichever markets offer the most attractive safe-haven yields.
Investors should not wait for a clear-cut signal before reassessing their positions.
To read my previous blog post, click here.