Investors are fleeing global sovereign bonds, driving yields and borrowing costs higher amid quickly rising interest rates and tightening liquidity in financial markets.
Central banks are hiking rates at the fastest pace in years to tackle soaring inflation. At the same time, they are reversing the stimulus programs that pumped up economies during COVID-19, removing pillars of support from government bond markets while other buyers remain cautious.
Bond yields are rising in response to those actions, with the global benchmark U.S. 10-year Treasury bond yielding 3.89% as of Oct. 7, up from 1.63% at the start of the year, and yields on global government debt are following suit.
Those higher yields are translating into higher borrowing costs for companies, countries and their residents. That trend shows little sign of slowing as persistent inflation forces the Federal Reserve and other central banks to keep pushing rates higher with little optimism for a policy shift.
"The combination of high inflation and central banks' determination to tame it — using rate hikes and quantitative tightening — is a predominant driver of higher yields at this point. At the margin, however, despite its early days, the Fed's [quantitative tightening] is putting some upward pressure on funding costs for banks and weighing on liquidity," said Anna Stupnytska, global macroeconomist at Fidelity International.
Banks pull on the reins
Yields on government debt have surged to levels last seen in 2010 when the Fed moved to buy government bonds through quantitative easing to revive the economy while the European Central Bank faced a debt crisis among the European Union's more debt-laden members.
Consumer price inflation rates of 8.3% in the U.S. and over 9% in the eurozone and the U.K. are pushing central banks to press ahead with further rate rises despite the risk of recession.
"The rise in bond yields is predominantly macro related, and so reflecting firstly the pandemic recovery in growth, but more pertinently the subsequent explosion in inflation, in turn necessitating big rises in central bank rates," said Padhraic Garvey, regional head of research for the Americas at ING.
Yields on government bonds are likely to keep rising as a result. Higher short-term interest rates, and the promise of more hikes to come, put pressure further down the curve as investors demand more premium for holding longer-dated debt, driving up yields. The Fed is compounding the reduced demand by not reinvesting the proceeds of maturing bonds on its balance sheet into the market, reducing liquidity.
The Fed, ECB, Bank of Japan and others bought trillions of dollars worth of government debt during COVID-19, supporting sovereign debt markets when most other investors were reluctant to do so.
The Bank of England went further than the Fed, announcing in September that it would begin the process of unwinding its balance sheet by actively selling bonds, testing the liquidity of the gilt market — the U.K. equivalent to Treasurys. This plan was derailed when liquidity drained out of the longer-dated gilt market after the U.K. government spooked markets with a tax-cutting package, forcing the bank to start buying bonds again.
The heightened sensitivity of government bond markets could be a sign of things to come as central banks continue to tighten policy.
No central bank pivot in sight
The prospects were raised when the Reserve Bank of Australia hiked by 25 basis points on October 4 rather than the 50 basis points seen in the previous four meetings. The language coming out of the Fed and elsewhere, however, has been more hawkish.
"Until I see some evidence that underlying inflation has solidly peaked and is hopefully headed back down, I'm not ready to declare a pause [in rate hikes]," Minneapolis Fed President Neel Kashkari said Oct. 6. "I think we're quite a ways away from a pause."
The inflation problem is a global one, caused by supply chain disruptions, a post-COVID-19 recovery in demand and the consequences of Russia's invasion of Ukraine on commodity prices. While rate rises can do little to address these problems, they can go toward addressing consumer demand, which has been buoyed by strong labor markets.
The latest data is supportive of further rate increases. U.S. job growth slowed modestly to 263,000 in September from 315,000 in August but was still above trend, while the unemployment rate dropped back down to the record low level of 3.5%. Similarly in the U.K., the latest labor numbers are strengthening the case for rate rises. HSBC expects the BoE to raise rates by 75 basis points at its Nov. 3 meeting.
"Bets that the era of central bank hawkishness has peaked is a dangerous game and hasn't worked very well this year," said Fawad Razaqzada, market analyst at StoneX. "We have repeatedly seen inflation data exceeding expectations and the Fed has correspondingly responded by being even more hawkish with its rate increases and language."
In Germany, producer input prices surged by 45.8% year over year in August. Those higher costs are forcing industrial closures in some cases and, in others, will feed through to higher consumer prices for goods like cars and electronics.
Even Japan, which has been battling deflation for decades due to its slow economic growth and declining population, recorded core inflation at a relatively hot 2.8% in August. So far, the bank has resisted rate hikes, maintaining its benchmark interest rate at negative 0.1%. But that is coming at a cost with the currency down more than 25% against the U.S. dollar this year.
While most central banks are committed to taming inflation, the strength of the U.S. dollar caused by the Fed's rate hikes is worsening the plight of other countries that import goods in dollars. There appears to be little relief on the way.
"Until we see strong hard data evidence of monetary policy tightening transmitting to the real economy, the Fed will continue on its hiking path," Stupnytska said.