Hamish Mcrae: Bond Yields Stoke Fear in the World of Finance
By Hamish Mcrae
Updated: 10:50 BST, 8 October 2023
Bond yields have become the dominant concern for the elite financiers attending the annual meetings of the International Monetary Fund and World Bank in Marrakech. The recent surge in bond yields has far-reaching implications for the world economy, including the potential collapse of financial institutions, the financial stability of nations, mortgage rates, and more.
Last week, the yield on the 30-year US Treasury bond surpassed 5% for the first time since 2007, while the 10-year rate, just below that level, is also at its highest since before the banking crash. The soaring bond yields have become a top concern at the IMF.
The United States, being the world’s largest borrower, is now paying higher interest rates to attract lenders than at any other point in the past 15 years. If rates were to rise to 6%, as some market insiders predict, it would mark the highest rate paid by the US government this century.
The impact of this goes beyond the US; the world is saturated with debt. All borrowers will face strain, and the entire global financial system will be affected. In such circumstances, it is difficult to predict which parts of the financial system will crack. As veteran investor Warren Buffet once put it, “Only when the tide goes out do you discover who’s been swimming naked.”
So where might the pressures eventually manifest? There are a few obvious possibilities. One is the risk of a US recession. Despite the challenges it has already faced, the US economy remains remarkably strong. However, renowned economist Mohamed El-Erian believes that the combination of rising yields and increasing inflation make a US recession much more likely. He also notes that mortgage rates are currently at their highest level in 23 years.
Sovereign debt problems are another vulnerable aspect. The yield on UK ten-year gilts now stands at over 4.6%. Although this is lower than US rates, it is higher than a year ago during the Truss/Kwarteng emergency Budget controversy. Spending more on servicing national debt means less cash available for tax cuts.
Other countries are in worse shape. Italy’s national debt is 145% of GDP, higher than the UK’s nearly 100%, and its ten-year bond yield has exceeded 5% in recent trading. France’s bond yield is sitting at 3.5%, the highest since 2011.
Most financial institutions have prepared for this scenario through stress-testing. However, there will inevitably be some institutions that aren’t prepared, and the overall impact on the global economy will be dampening.
As for investors, last year saw many UK pension funds blindsided by the surge in gilt yields. This exposed the flaw in considering gilts as low-risk, especially when mandated to hold them.
A similar story can be told for US government debt. Those who bought 30-year Treasuries in early 2022 lost half their investment. This is tantamount to buying equities at the height of the dot-com bubble in 2000. Personally, I have always believed that equities, particularly in undervalued markets like the UK, are inherently safer than fixed-interest securities such as gilts.
However, there is one potential downside for equities. They may be adversely affected by the turmoil in fixed-interest markets. There are two factors at play here. Firstly, if a US recession does occur, it will have a global impact, leading to lower corporate earnings. This potential decline is not yet priced into US equities, including large-cap stocks.
Secondly, if investors find themselves needing to raise cash and wanting to avoid realizing losses on fixed-interest portfolios, they may choose to sell some of their equity holdings where they still have decent profits.
While it may not be a significant concern, it is worth noting that October is historically a month prone to sudden equity sell-offs.
In Marrakech, the weather is sunny with temperatures expected to reach 37°C this week. However, for those managing a nation’s budget or a financial services company, the winds are likely to be chilly upon returning home.
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