Why are markets panicking over surging US bond yields

Subject : Economy

Section: External Sector

In News: US bonds in a downward trend with rising yields.

Key Points:

The US treasury bond market which had been in a bull market that peaked out in 2020, has now started to reverse aggressively.
The US 30-year bond which had a yield of around 9 per cent in 1988, had dipped to below 1 per cent in 2020 (when yields decline bond prices go up).
In this intervening period the risk-free 30-year bond index had outperformed the stock market benchmark, S&P 500 total return.
Now with the 30 year bond now yielding 4.96 per cent, it is now at levels last seen in 2007. So is the 10 year bond which is yielding 4.79 per cent.

What is causing the increase in yields?

Persistent inflation:

With persistent inflation, investors believe the US is likely to have long-term inflation around 3 per cent, with changed structural dynamics in the global economy post covid.
For holding bonds they want compensation for that inflation and a premium over that.
Typically investors in 10-year yields may expect at least a 1.5 per cent premium over inflation.
There is also a concern that the Fed’s pause on rate hikes may be premature. And so if Central Banks don’t do their job, the markets seems to be pricing the interest expectation for the Central Bank.

Large bond issuances:

US fiscal deficit for FY23 (ending September) has doubled to two trillion from around one trillion in FY22.
With the Fed too not doing quantitative easing (QE/buying bonds anymore), the flood of bond issuances to fund the spending has further altered the supply-demand landscape for bonds.

Global macro/geopolitical factors:

China has been reducing its holdings of US bonds. This could be due to a combination of economic as well as geopolitical factors.
Further, there are risks that Japanese holders of US treasury bonds (large holders) may unwind as bond yields in Japan increase making the US investment less attractive.
Many economists are of the view that Japan’s Central Bank may be forced to abandon its yield curve control and allow yields to move up as macro economic/inflationary pressures mount

Why are equity markets selling off?

Higher risk free yields make risk assets less attractive.
During covid-19 (CY20) when interest rates were so low and equities saw a bull run, as there were no alternative to equities. Now bonds are emerging as compelling alternatives to equities.

Possibilities of cooling of the US t-bond yields:

Volatility in bond yields may lead to a credit event causing an abrupt slowdown in economy which will trigger rate cuts/QE by the US Fed.
Another plausible path for cooling of yields is that the current levels of interest rates will slow down the economy enough or result in a mild recession next year, resulting in cooling of inflation. This will consequently result in cooling of bond yields as well.
There is also a risk of stagflation where economy could be in recession, but inflation remains high like it happened in the 1970s in countries like US and UK.