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The bond market is crumbling. That’s bad for Wall Street and Main Street

By Nicole Goodkind, CNN Business

The global bond market is having a historically awful year.

The yield on the 10-year US Treasury bond, a proxy for borrowing costs, briefly moved above 4% on Wednesday for the first time in 12 years. That’s a bad omen for Wall Street and Main Street.

What’s happening: This hasn’t been a pretty year for US stocks. All three major indexes are in a bear market, down more than 20% from recent highs, and analysts predict more pain ahead. When things are this bad, investors seek safety in Treasury bonds, which have low returns but are also considered low-risk (As loans to the US government, Treasury notes are seen as a safe bet since there is little risk they won’t be paid back).

But in 2022’s topsy-turvy economy, even that safe haven has become somewhat treacherous.

Bond returns, or yields, rise as their prices fall. Under normal market conditions, a rising yield should mean that there’s less demand for bonds because investors would rather put their money into higher-risk (and higher-reward) stocks.

Instead markets are plummeting, and investors are flocking out of risky stocks, but yields are going up. What gives?

Blame the Fed. Persistent inflation has led the Federal Reserve to fight back by aggressively hiking interest rates, and as a result the yields on US Treasury bonds have soared.

Economic turmoil in the United Kingdom and European Union has also caused the value of both the British pound and the euro to fall dramatically when compared to the US dollar. Dollar strength typically coincides with higher bond rates as well.

So while we’d normally see a rising 10-year yield as a signal that US investors have a rosy economic outlook, that isn’t the case this time. Gloomy investors are predicting more interest rate hikes and a higher chance of recession.

What it means: Portfolios are aching. Vanguard’s $514.5 billion Total Bond Market Index, the largest US bond fund, is down more than 15% so far this year. That puts it on track for its worst year since it was created in 1986. The iShares 20+ Year Treasury bond fund (TLT) is down nearly 30% for the year.

Stock investors are also nervously eyeing Treasuries. High yields make it more expensive for companies to borrow money, and that extra cost could lower earnings expectations. Companies with significant debt levels may not be able to afford higher financing costs at all.

Main Street doesn’t get a break, either. An elevated 10-year Treasury return means more expensive loans on cars, credit cards and even student debt. It also means higher mortgage rates: The spike has already helped push the average rate for a 30-year mortgage above 6% for the first time since 2008.

Going deeper: Still, investors are more nervous about the immediate future than the longer term. That’s spurred an inverted yield curve — when interest rates on short-term bonds move higher than those on long-term bonds. The inverted yield curve is a particularly ominous warning sign that has correctly predicted almost every recession over the past 60 years.

The curve first inverted in April, and then again this summer. The two-year treasury yield has soared in the last week, and now hovers above 4.3%, deepening that gap.

On Monday, a team at BNP Paribas predicted that the inverted gap between the two-year and 10-year Treasury yields could grow to its largest level since the early 1980s. Those years were marked by sticky inflation, interest rates near 20% and a very deep recession.

What’s next: The bond market may face fresh volatility on Friday with the release of the Federal Reserve’s favored inflation measure, the Personal Consumption Expenditure Price Index for August. If the report comes in above expectations, expect bond yields to move even higher.

The Bank of England steps in to save pensions

The Bank of England held an emergency intervention to maintain economic stability in the UK on Wednesday. The central bank said it would buy long-dated UK government bonds “on whatever scale is necessary” to prevent a market crash.

Investors around the globe have been dumping the British pound and UK bonds since the government on Friday unveiled a huge package of tax cuts, spending and increased borrowing aimed at getting the economy moving and protecting households and businesses from sky-high energy bills this winter, reports my colleague Mark Thompson.

Markets fear the plan will drive up already persistent inflation, forcing the Bank of England to push interest rates as high as 6% next spring, from 2.25% at present. Mortgage markets have been in turmoil all week as lenders have struggled to price their loans. Hundreds of products have been withdrawn.

“This repricing [of UK assets] has become more significant in the past day — and it is particularly affecting long-dated UK government debt,” the central bank said in its statement.

“Were dysfunction in this market to continue or worsen, there would be a material risk to UK financial stability. This would lead to an unwarranted tightening of financing conditions and a reduction of the flow of credit to the real economy.”

Many final salary, or defined-benefit, pension funds were particularly exposed to the dramatic sell-off in longer dated UK government bonds.

“They would have been wiped out,” said Kerrin Rosenberg, UK chief executive of Cardano Investment.

The central bank said it would buy long-dated UK government bonds until October 14.

The silver-lining case for bonds

Steep drops in bond prices may be signaling doom and gloom for the economy, but some analysts say short-term bonds are still looking more attractive than equities right now.

“Record low yields have kept fixed income in the shadow of equities for decades,” said Andy Tepper, Managing Director at BNY Mellon Wealth Management. “But the aggressive shift in Fed policy is beginning to change this.”

Central banks around the globe have responded to elevated inflation by hiking interest rates– and bond yields have increased alongside them. The two-year US Treasury bond is currently yielding nearly 4%. That’s still a relatively low return, but better than the S&P 500’s dividend yield of around 1.7%.

“For the first time in several years, bonds are attractive investment options. In addition to providing diversification versus equities…you now get paid for owning them,” wrote Barry Ritholtz of Ritholtz Wealth Management on Wednesday.

Consider the alternative: the S&P is down more than 20% year to date.

Up next

The US Bureau of Economic Analysis releases its third estimate for Q2 GDP and US weekly jobless claims.

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