(Bloomberg) — Not so long ago, families, businesses and governments were effectively living in a world of free money.
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The US Federal Reserve’s benchmark interest rate was zero, while central banks in Europe and Asia even ran negative rates to stimulate economic growth after the financial crisis and through the pandemic.
Those days now look to be over and everything from housing to mergers and acquisitions are being upended, especially after 30-year US Treasury bond yields this week punched through 5% for the first time since 2007.
“I struggle to see how the recent yield moves don’t increase the risk of an accident somewhere in the financial system given the relatively abrupt end over recent quarters of a near decade and a half where the authorities did everything they could to control yields,” said Jim Reid, a strategist at Deutsche Bank AG. “So, risky times.”
The importance of Treasuries helps to explain why the bond-market move matters to the real world. As the basic risk-free rate, all other investments are benchmarked against them, and as the Treasury yield rises, so that ripples out to broader markets, affecting from everything from car loans to overdrafts to public borrowing and the cost of funding a corporate takeover.
And there’s a lot of debt out there: According to the Institute of International Finance, a record $307 trillion was outstanding in the first half of 2023.
There are lots of reasons for the dramatic bond-market shift, but three stand out.
Economies, especially the US, have proved more robust than anticipated. That, along with the previous dollops of easy money, is keeping the fire lit under inflation, forcing central banks to jack up rates higher than once thought and, more recently, stress that they’ll leave them there for a while. As recession fears have ebbed, the idea that policy makers will have to quickly reverse course – the so-called pivot – is fast losing traction.
Finally, governments issued a lot more debt — at low rates — during the pandemic to safeguard their economies. Now they have to refinance that at a much costlier price, sowing concerns about unsustainable fiscal deficits. Political dysfunction and credit rating downgrades have added to the headwinds.
Put all these together and the price of money has to go up. And this new, higher level portends major changes across the financial system and the economies it feeds. Some money-market funds and even bank deposits are now offering a 5% handle. The German 10-year yield is at the highest since 2011, while even Japan’s is at a level not seen in a decade.
Housing Market Pain
For many consumers, mortgages are the first place that dramatic moves in interest rates really make their presence felt. The UK has been a prime example this year. Many who took advantage of pandemic-era stimulus to take out a cheap deal are now having to refinance, and are facing a shocking jump in their monthly payments.
As a result, transactions are falling and house prices are under pressure. Lenders are also seeing a rise in defaults, with one measure in a Bank of England survey rising in the second quarter to the highest level since the global financial crisis.
The mortgage-cost squeeze is a story playing out everywhere. In the US, the 30-year fixed rate has surpassed 7.5%, compared with about 3% in 2021. That more-than-doubling in rates means that, for a $500,000 mortgage, monthly payments are roughly $1,400 extra.
Higher rates mean countries have to shell out more to borrow. In some cases, a lot more. In the 11 months through August, the interest bill on US government debt totaled $808 billion, up about $130 billion from the previous year.
That bill will keep going up the longer rates stay elevated. In turn, the government may have to borrow even more, or choose to spend less money elsewhere.
Treasury Secretary Janet Yellen this week said yields are something that’s been on her mind. Adding to the market tensions, the US has been in the throes of yet another political crisis over spending, threatening a government shutdown.
Others are also trying to deal with bloated deficits, partly the result of pandemic stimulus. The UK is looking to limit spending, and some German politicians want to reinstate a ceiling on borrowing known as the debt brake.
Ultimately, as governments try to be more fiscally responsible, or at least give that impression, the burden falls on households. They’re likely to face higher taxes than otherwise along with suffering financially strained public services.
Stock Market Risk
US Treasuries are considered one of the safest investments on the planet, and in the last decade or so the rewards for holding them were modest given suppressed yields. As they now approach the 5% mark, these bonds are looking much more attractive than risker assets, such as stocks.
One metric under close scrutiny is the equity risk premium, the difference between the earnings yield of the S&P 500 index and the 10-year Treasury yield, which is a way of gauging the attractiveness of stocks versus other assets. That stands near zero, the lowest in more than two decades, implying that stock investors aren’t being rewarded for taking on any additional risk.
Ian Lyngen, head of interest-rate strategy at BMO Capital Markets, cautioned on Bloomberg Television this week that if the 10-year hit 5%, that could prove an “inflection point” that triggers a broader selloff in risk assets such as stocks. “That’s the biggest wildcard.”
Why UK Mortgages Are Especially Exposed to Rate Hikes
Why US Deficit Is a Worry Again, and Will Remain So
Companies spent the last decade raising cash at really cheap rates, basing their business models on the assumption that they’d have access to markets if they needed more money. That’s all changed, but most firms raised so much when rates were near zero that they didn’t need to tap markets when the hiking cycle began.
The problem now is “higher for longer.” Weaker companies that had been relying on their cash cushions to make it through this period of higher funding costs may be forced to tap markets to deal with a wall of debt that’s coming due. And if they do, they’ll need to pay almost double their current debt costs for cash.
Such strains could mean corporates have to scale back investment plans or even look for savings, which may translate to job losses. Such actions, if widespread, would have implications for consumer spending, housing and economic growth.
The changed world will also be a test for some of the newer corners of funding, such as private credit, which has yet to show how it would handle corporate defaults.
Higher rates have negatively impacted banks’ willingness to back large mergers and acquisitions over the last 18 months, with lenders fearful of being left with debt on their books that they can’t sell on to investors.
This has led to a steep fall in leveraged buyouts, a lifeblood of healthy M&A markets. Global transaction values stood at $1.9 trillion at the end of September, Bloomberg-compiled data show, leaving dealmakers on course for their worst year in a decade.
Private equity firms have been particularly affected, with the value of their acquisitions falling 45% this year to about $384 billion, the second consecutive year of double-digit percentage declines.
In the absence of cheap debt to help boost returns, some firms, including giants like KKR & Co., have been writing bigger equity checks to get deals done, while others have been opting for minority stake purchases. At the same time, PE firms have found it harder to sell assets, leading to delays in returning money to investors and impacting their ability to raise new funds.
Office Debt Timebomb
Commercial real estate is a sector heavily reliant on borrowing vast sums, so the jump in debt costs is poison for the sector. Higher bond yields have slammed valuations on properties as buyers demand returns that offer a premium over the risk free rate.
That’s bumped up loan-to-value ratios and increased the risk of breaching debt terms. Borrowers face the choice of injecting more equity, if they have it, or borrowing more at costlier rates.
The other option is to sell properties into a falling market, creating more downward pressure on prices and in turn causing more trouble for finances.
Compounding all of this is the structural shift that’s hitting offices, as changing work habits and rising environmental regulations combine to make swathes of real estate’s biggest sub-sector obsolete, echoing the downturn that’s already pummeled malls.
While a broader turmoil could emerge from anywhere, it’s worth noting that property crises have frequently been the germ for a wider banking crisis.
Lately, both bonds and stocks have been going down. That’s not ideal for defined-benefit pension funds that tend to use the classic 60/40 strategy, of 60% equities and 40% bonds.
But once Treasuries trough, the new, higher rates that they offer could prove an attraction to many current retirees. A gauge of inflation-adjusted yields this week surpassed 2.40%, which is a whole lot better than the negative 1% seen as recently as last year. Amid a cost-of-living crisis, positive real return would be welcomed by many.
If higher yields are good because they improve funding positions, steep rises can throw up unexpected problems. That was the case in the UK last year, when a shock government budget announcement brought mayhem to the gilt market, hitting pension schemes using so-called liability driven investments. Those trades typically use leverage to help funds match assets with liabilities and got slammed by margin calls after a bond selloff.
Other pension funds have also been caught out by higher rates. Sweden’s Alecta was hit by a local real-estate slump because of its investment in heavily indebted landlord Heimstaden Bostad. It also lost lost 20 billion kronor ($1.8 billion) on failed bets in US lenders, including Silicon Valley Bank.
Central Banks Aren’t Wavering
Amid the market ructions, central bankers aren’t showing signs that they are wavering and ready to rush in to save the day.
That’s because Fed Chair Jerome Powell and his counterparts around the world have been focused on trying to slow their economies to a sustainable speed in order to get sky-high inflation down. There’s a risk that the slowdown becomes too pronounced, but for now, central bankers seem set in their position.
“Investors have tried to price this Fed pivot so many times,” said Johanna Kyrklund, co-head of investment at Schroder Investment Management. “The Fed has actually been very consistent in saying they are in no rush to cut rates, so maybe we should just listen to what they are saying.”
She likens the bond selloff to the bursting of the dot-com bubble two decades ago, when some “fundamental assumptions had to be revisited.”
“The same has happened with the bond market,” Kyrklund said. “New ranges are required and the last two years have been about bond investors getting used to that fact and accepting that we’re not going back to what was true the last 10 years.”
–With assistance from Steven Arons, Silas Brown, Constantine Courcoulas, Dana El Baltaji, Alice Gledhill, Loukia Gyftopoulou, Tom Metcalf, Giulia Morpurgo, Fareed Sahloul, Damian Shepherd, Tasos Vossos and Francine Lacqua.
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