Bond markets, famously, can scare everyone. And if you aren’t scared by what’s happening with them yet, maybe you should be paying more attention.
In less than three months, long-term interest rates have risen nearly a full percentage point in the U.S., dragging up borrowing costs for governments, companies and households around the world.
And they don’t show any sign of stopping yet. The yield on the 10-year U.S. Treasury, the world benchmark for long-term capital, rose another 0.11 percentage points on Tuesday to a new 16-year high after another surprisingly strong set of data from the U.S. labor market, which forced market participants to push back their expectations of an American recession yet again. In Europe, its German counterpart, the 10-year Bund, is now yielding nearly 3 percent, a level it hasn’t seen since 2011.
As Deutsche Bank strategist Jim Reid pointed out, the weekend deal to avoid a U.S. government shutdown has, if anything, made things worse in the near term for bonds, “as it removed a tangible risk for the economy” and made it easier for the Federal Reserve to carry on raising interest rates. Markets now see another Fed hike as more likely than not before year-end.
But that’s only half the story. Normally, rising long-term rates (expressed by government bond yields) go hand-in-hand with stronger economic growth and expectations of future inflation. That is not the case this time. Both the European and — despite the labor market data — U.S. economies are broadly slowing, and that is making it harder for China, the world’s second-biggest economy, to generate any sort of economic momentum of its own. Rising interest rates at a time of weak or faltering growth spells double trouble for governments, who have to pay more to cover their budget deficits as a result.
What goes around comes around
This is the long-anticipated economic hangover from the pandemic. Having thrown money at the problems caused by COVID-19, the West is now having to rein in the inflation it has caused. In the U.S., the eurozone and the U.K., central banks are draining liquidity from the financial system, making money scarcer and pushing its price up to levels not seen since 2007.
But at the same time, governments are still gasping for cash: The U.S. Treasury alone plans to borrow $1.85 trillion from markets in the second half of this year, to replenish its coffers after a bruising debt ceiling standoff and to fund a yawning budget gap.
Two of the eurozone’s three largest economies, France and Italy, both presented budget drafts for 2024 last week that widely overshot previous estimates, and on Tuesday, the French Trésor published data showing that the public sector funding gap so far this year was up 25 percent from a year earlier, at €188 billion.
And while it’s the U.S. Federal Reserve that has set the pace as regards the tightening of global financial conditions, it’s in Europe and in emerging markets that the effects are being felt strongest, as a rising dollar again pushes the price of oil and other essential imports to extreme highs.
“In trying to match Fed tightening and protect their currencies, some central banks – particularly in Europe – have been whipsawed into raising rates too aggressively,” Dario Perkins, head of global macro research at TS Lombard, said in a recent note to clients. “The US post-COVID party has become a European hangover, another instalment of America’s exorbitant privilege.”
