How The Bond Market Surprised Investors

The bond market caught investors unaware over the summer, and there’s probably more of that to come. Investors believed interest rates bottomed last November.

Futures markets forecast that through 2023, the Federal Reserve would ease monetary policy, and interest rates would decline rapidly. Even as inflation remained above expectations and the Fed tightened policy, investors expected a rapid turnaround. Market interest rates declined steadily through early May. The stalemate finally broke over the summer. Bond markets turned sharply lower as most interest rates bounced to their highest levels in 15 years or longer.

The long-term treasury bond exchange-traded fund (ETF) is down 6.74% over the last three months after being up more than 6% through April this year. Investors were fooled largely because the U.S. Treasury’s cash management strategies influenced the bond market in the short term. To avoid issuing a lot of bonds despite the rising budget deficit, the Treasury spent its cash, bringing cash balances to low levels. It also issued more short- term treasury bills than usual instead of issuing bonds.

Typically, Treasury issues bills and bonds with a balance of durations. The Treasury Department finally hit its self-imposed limit on short-term debt and started issuing bonds. The steady increase of bonds coming to market raised market interest rates even though Fed policy didn’t change. The 10-year treasury bond yield went from 3.30% in early April to 4.34% in late August.

It has since declined a little but is still above 4.00%. The 10-year treasury yield exceeded the dividend yield on utility stocks for the first time since 1998. The yield on the 30-year treasury bond went from 3.61% to 4.45% and is still above 4.20%. Real yields on treasury bonds (market yields adjusted for inflation) hit their highest levels since the financial crisis. Real yields on short-term debt reached levels not seen since the 1980s.

Yet, the economy is strong enough that inflation isn’t likely to drop to the Fed’s target without higher interest rates. Investors slowly are realizing interest rates are going to rise some more and stay higher for longer than they were expecting.

It is also becoming apparent that the Fed’s quantitative tightening policy will be in place for a considerable time. The Fed isn’t going to reduce the interest rates it controls in the near future and won’t return to quantitative easing unless there’s a severe recession.

Higher interest rates, especially real interest rates, are bad for financial assets. Stock prices also are under pressure from other economic trends. While inflation is well below the 2022 peak, the rate of decline slowed. It looks like inflation will stabilize at an annualized rate above 3% unless economic activity or incomes fall. Investors were betting inflation would return to the Fed’s target with- out a recession. More investors gradually are accepting the possibility of a mild recession.

Parts of the U.S. economy have been weak, and the weakness slowly is spreading. Sustained higher interest rates will weaken more sectors of the economy. In addition, China isn’t providing the expected support for global growth. Recent data indicate China might be in or on the verge of a recession, and its growth isn’t likely to improve soon.

The banking crisis we had in the spring also limits growth. Bank capital is reduced, forcing banks to limit the number of loans made and impose tougher lending standards. Households are relying on higher stock prices, because they have a high- er percentage of their financial assets in stocks than at any time since the late 1990s. All these factors don’t leave much of a margin of safety in U.S. stocks and bonds today. It is a good time to be diversified among different assets and parts of the world.