Unlike central banks, private investors are price-sensitive and want compensation for the risk and uncertainty they’re taking on with the bond market volatile, the future course of US interest rates uncertain, chaos reining in Congress and the wars in Ukraine and the Middle East.
That’s being reflected in the return of the “term premium,” or the extra yield investors want for the risks of holding longer-dated securities relative to those with shorter durations. While that premium can’t be observed, it can be inferred, and it seems that it is now significantly positive for the first time in a long time.
Previously that premium, along with the yield curve, was suppressed by the Fed’s interventions, where its near-zero rates policy, buttressed by its quantitative easing (buying of bonds and mortgages), essentially flattened the yield curve and squashed term premiums for most of the period since the global financial crisis.
‘Bond vigilantes’ are back
With the Fed’s buying underwriting the market, there was not much additional risk, if any, in buying 10-year bonds rather than one-year notes.
With the Fed now withdrawing, and private investors driving the pricing of bonds in an environment where the US fiscal position is deteriorating quite rapidly, the “bond vigilantes,” as investment strategist Ed Yardeni described them in the early 1980s, are now back in the driver’s seat.
They are doing the Fed’s work for it by raising the rates that impact the real economy directly and inevitably imposing some discipline on America’s fiscal profligacy through the impact of much higher rates on the increased debt.
The extent of the rate rises so far and the rate at which they have risen is surely going to end up breaking something. Such a movement in the cost of borrowings after a decade and a half of negligible borrowing costs is inevitably going to cause some borrowers and investors grief.
The US sharemarket is now down more than 8 per cent in less than three months and 11.5 per cent off its record level, reached at the end of 2021.
The 10-year bond rate is the benchmark rate used to discount estimates of future earnings and cash flows to arrive at company valuations, so it isn’t surprising that the sharemarket has been falling as yields have risen.
It is also the reference rate for the pricing of corporate debt.
So far, however, even though spreads – the interest rates companies pay over the relevant government bond yield – have blown out, there hasn’t yet been any observable material deterioration in credit quality even at the higher-risk, higher-yield “junk” end of the corporate debt market. So far.
US commercial real estate ought to be under pressure, along with the regional banks who do most of the commercial property lending, but while there is increasing concern about the risks of an implosion that would also envelop the regional banks (who are also sitting on massive unrealised losses on their bond holdings) it has yet to materialise.
With long-term fixed rate mortgages, the residential property sector in the US isn’t as immediately impacted as Australia’s where floating or variable rates are the norm, but that doesn’t mean house prices are unaffected, or that housing market activity won’t decline when mortgage rates have been rising on a weekly basis.
There is a point, of course, where increased yields will have a material impact on all those risk assets and will, in the process, choke off growth in a US economy that has proven, so far, to be more resilient than expected.
The extent of the rate rises so far and the rate at which they have risen is surely going to end up breaking something.
For other economies, the stronger US dollar caused by its higher interest rates is causing currency depreciations and compounding the increase in the cost of repaying or servicing US dollar-denominated debt, a particular issue for developing economies.
It’s also generating volatility – in the last fortnight the Australian dollar, for instance, has tumbled nearly a cent against the US dollar – and adding to the financing and refinancing costs of those accessing the US corporate debt markets.
The major Australian banks, for instance, last month made their second-last repayment (the last will be in June next year) of the Reserve Bank’s $200 billion term funding facility, with its coupon of only 0.1 per cent.
That debt will have to be refinanced at rates in the US markets that will be at least mid-single digits, adding to their interest costs, the pressure on their net interest margins and the pricing of credit/returns for depositors for their customers.
The fact that interest rates in the US and elsewhere are tracking back towards their pre-financial crisis norms could be regarded as reassuring. The aberrant era of unconventional monetary policies is receding.
That era, however, encouraged and was designed to encourage risk taking, and resulted in the prices of all risk assets being inflated by the actions the central bankers took. They encouraged the explosion of borrowing with their negligible rates.
Those unconventional policies are now being steadily unwound and private sector investors are reasserting themselves. To borrow once again from Warren Buffett, once the tide goes out, we’ll see who has been swimming naked. It could be an ugly sight.
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