The benchmark interest rate set by the US Federal Reserve was zero, while central banks in Europe and Asia even used negative interest rates to boost the economy during the pandemic and after the financial crisis.
After 30-year US Treasury bond yields this week broke through 5% for the first time since 2007, those days now appear to be over, and everything from housing to mergers and acquisitions is being upended. After a larger-than-expected increase in US payrolls, which strengthened the case for additional Fed rate hikes, yields saw an increase on Friday.
There is also a lot of debt in the world: The Institute of International Finance estimates that in the first half of 2023, outstanding debt reached a record $307 trillion.
Continue reading: Corporate America Ignores Jay Powell and Obsessively Chases Debt
There are several causes for the abrupt change in the bond market, but three stand out.The strength of economies, particularly the US economy, has exceeded expectations. This, combined with earlier doles of easy money, is keeping the inflation fire burning, compelling central banks to raise rates higher than initially anticipated and, more recently, to emphasise that they’ll keep them there for a while. The notion that policymakers will need to abruptly alter course — the so-called pivot — has been losing ground as recession concerns have subsided.
Finally, during the epidemic, governments issued a lot more debt—at low rates—to protect their economies. Now that they must renew that debt at a much higher cost, worries about unmanageable fiscal deficits are being raised. The obstacles have been exacerbated by political turmoil and credit rating downgrades.
When you combine all of them, the cost of money must increase. Additionally, this new, higher level heralds significant changes for the financial system as well as the economy it supports.
The 10-year Treasury yield increased by more than 15 basis points to 4.89% on Friday. The rate in Germany increased by 8 basis points to reapproach 3% after already approaching its highest level since 2011. The actions were motivated by a US data that showed the economy added 336,000 jobs in November, about twice as many as expected.
Painful Housing Market
For a lot of customers, mortgages are where sudden changes in interest rates first start to be felt. This year, the UK has served as a shining example. Many people who took advantage of the stimulus during the pandemic to get a good deal now have to refinance and are faced with a startling increase in their monthly expenses.
The outcome is a decline in transactions and pressure on home prices. Additionally, defaults are increasing for lenders, with one indicator in a Bank of England survey reaching its highest level since the global financial crisis in the second quarter.
Everywhere, a tale about the squeeze on mortgage costs is being told. The 30-year fixed rate in the US has risen beyond 7.5%, up from roughly 3% in 2021. With rates more than tripling, there will be an additional $1,400 in monthly payments for a $500,000 mortgage.
Higher rates result in increased borrowing costs for nations. Sometimes, much more. The cost of interest on the US government debt in the 11 months leading up to August came to $808 billion, an increase of roughly $130 billion from the previous year.
The longer rates remain high, the more expensive that bill will become. The government might then be forced to take out even more debt or decide to cut back on spending in other areas.
This week, Treasury Secretary Janet Yellen stated that yields have been on her mind. The US has been engulfed in yet another political crisis over spending, threatening a government shutdown, adding to the market concerns.
Others are also attempting to address the ballooning deficits that have been exacerbated in part by epidemic stimulus. The UK wants to restrict spending, and some German lawmakers want to bring back the debt brake, a borrowing cap.
Ultimately, the cost falls on consumers as governments attempt to be more fiscally prudent, or at least give that idea. They’ll probably pay more taxes than they would otherwise, and public services will be cut back because of the economy.
Investment Risk
US Treasuries are among the safest assets available, and in the past ten years or so, keeping them has yielded small returns due to low yields. These bonds are significantly more appealing than riskier investments like stocks when they get closer to the 5% barrier.
A measure used to compare the attractiveness of stocks to other assets is the equity risk premium, which is calculated as the difference between the earnings yield of the S&P 500 index and the yield on the 10-year Treasury. That figure is very close to zero, the lowest in more than 20 years, and it suggests that stock investors aren’t getting paid extra to take on more risk.
This week on Bloomberg Television, Ian Lyngen, head of interest-rate strategy at BMO Capital Markets, issued a warning that if the 10-year yield reached 5%, that may prove to be a “inflection point” that causes a larger selloff in risky assets like stocks. The biggest wildcard is “that.”
Companies raised money at extremely low rates over the past ten years, building their business plans around the idea that they would have access to markets in the event that they required further funding. All of that has changed, but the majority of businesses raised so much while rates were close to zero that they didn’t need to access the market when the cycle of rate increases started.
Now, the issue is “higher for longer.” Weaker businesses who relied on their cash reserves to get them through this period of higher funding expenses might be obliged to turn to the markets in order to deal with a mountain of debt that is approaching due date. And if they do, they’ll have to pay about twice as much in cash in debt as they do now.
These pressures could force corporations to curtail their investment plans or even hunt for savings, which could result in job losses. If widely practised, such acts would have an impact on housing, consumer spending, and economic expansion.
The new financial landscape will also put some of the more recent sources of capital to the test because they haven’t yet demonstrated how they can handle business defaults, such private credit.
Deals are scarce
Over the past 18 months, higher rates have had a detrimental influence on banks’ willingness to support significant mergers and acquisitions because lenders are afraid of being left with debt on their books that they can’t sell to investors.
As a result, leveraged buyouts, which are essential to thriving M&A markets, have seen a sharp decline. According to figures published by Bloomberg, the value of global transactions stood at $1.9 trillion at the end of September, putting dealmakers on track to have their worst year in ten years.
The value of private equity companies’ acquisitions fell by 45% this year to around $384 billion, marking the second year in a row that the value of these acquisitions fell by double digit percentages.
Since the commercial real estate industry depends so largely on large-scale borrowing, the increase in debt costs is poison for the industry. Property prices have been severely impacted by higher bond yields because investors want returns that are higher than the risk-free rate.
This has raised loan-to-value ratios and raised the possibility of debt conditions being broken. The borrower must decide whether to increase their equity contribution, if they have any, or take on more debt at a higher cost.
The alternative is to sell real estate in a weak market, which would further compress prices and complicate matters financially.
Compounding all of this is the structural shift that is affecting offices, which will render large portions of the largest sub-sector of real estate obsolete due to shifting work patterns and increasing environmental restrictions, echoing the downturn that has already severely hurt malls.
Even if a larger upheaval could start from anyplace, it’s important to remember that property crises typically serve as the seed for a larger banking crisis.
hit pensions
Both bonds and stocks have been declining recently. This is not suitable for defined-benefit pension plans, which often employ the traditional 60/40 approach, which invests 60% in stocks and 40% in bonds.
The new, higher rates that Treasuries offer, however, may prove to be attractive to many current retirees whenever they reach their bottom. This week, a measure of inflation-adjusted rates exceeded 2.40%, a significant improvement from the negative 1% observed only last year. Positive real return in the midst of a cost-of-living crisis would be embraced by many.
If greater returns are advantageous because they strengthen funding positions, then large increases may present unforeseen issues. This happened in the UK the previous year when a shocking government budget statement destabilised the gilt market and hurt pension plans using so-called liability driven investments. These trades were hit hard by margin calls following a bond selloff because they frequently use leverage to assist funds match assets with liabilities.
Higher rates have also surprised some pension funds. Due to its stake in the highly indebted landlord Heimstaden Bostad, Swedish company Alecta was impacted by the local real estate downturn. On failed bets in US institutions, including Silicon Valley Bank, it also lost 20 billion kronor ($1.8 billion).
Central Banks Remain Stable
Despite the market turbulence, central bankers aren’t flinching or preparing to swoop in to save the day.
This comes as a result of Fed Chair Jerome Powell and his global counterparts’ efforts to slow their economies to a sustainable pace in an effort to lower sky-high inflation. The slowdown could grow too severe, but for the time being, central bankers appear to be steadfast in their position.
The Fed’s move has been priced by investors numerous times, according to Johanna Kyrklund, co-head of investment at Schroder Investment Management. The Fed has actually consistently stated that it is not in a haste to decrease interest rates, so perhaps we should just pay attention to what they are saying.
She compares the bond sell-off to the dot-com bubble implosion of two decades earlier, when certain “fundamental assumptions had to be revisited.”
The bond market has experienced the same things, according to Kyrklund. The last two years have been about bond investors get accustomed to that fact and understanding that things won’t go back to how they were in the previous ten years. New ranges are necessary.