The ten-year US Treasury yield is arguably the most important interest rate in the world.
Yesterday, it hit its highest level since 2011. This morning it’s still rising – heading above 3.2%. It’s not so long ago that we were fretting about the 3% level as being a key “line in the sand”.
So what happens now?
A quick refresher course on bonds
When a government or a company wants to borrow money from investors, it issues a bond. A bond is just an IOU. The holder is entitled to an annual payment (coupon) plus they get the face value of the bond back at the end of the loan period (the maturity date).
You can then buy or sell these IOUs in the secondary market. So, say someone issues a bond at £100 with a coupon of £5. That’s a 5% yield. Assuming the issuer is a good credit risk (the US government, say), then that would be a very desirable investment just now.
So rather than pay £100 for the bond, investors would be willing to pay rather more. Probably more like £130, which would reduce the yield to below 4%.
That’s a simple example that gives you the main points you need to know about bonds. The yield is what matters – which is why bonds are usually quoted in terms of yields, whereas equites are quoted in terms of prices. And when yields rise, prices fall, and vice versa.
So – let’s get back to the topic of the day, which is US ten-year bond yields. Why are they going up?
First, the US economy is growing strongly. You can poke holes in the data all you want, but while it’s certainly worth keeping an eye out for evidence that the economy is on the turn, getting het up about the “under-employment” rate is mostly a waste of your time.
When the economy is growing strongly, other assets look more attractive. You don’t need the safety of a bond, you want the potential returns of a growth stock, say. So that’s one factor.
Second, strong growth tends to mean inflation. Bonds feel the same way about inflation that Superman feels about kryptonite. Most bonds pay a fixed coupon, so that becomes less and less valuable in “real” terms as inflation rises.
If prices are rising at 5% a year, and your money is earning 5% interest, then by the end of that year, you are in reality no better off. So when inflation is going up, bond yields need to rise too.
Inflation hasn’t taken off yet. But the signs are there – from Amazon increasing its minimum wage to the oil price surging. One factor behind yesterday’s push higher in yields was a particularly strong private sector jobs survey from ADP.
If that’s reflected in this Friday’s non-farm payrolls report – and if wages in particular genuinely push higher – markets may finally be convinced that inflation, rather than deflation, is the big risk.
Third, there are fewer buyers out there. The European Central Bank is planning to cut back on quantitative easing (QE).
When a central bank does QE, it (mostly) buys government bonds. But in doing so, it crowds out other buyers or holders of these bonds. They have to buy something else.
If QE is set to stop (as it already has in the US), then those buyers won’t need to go elsewhere anymore. We may already be seeing the impact. On balance, eurozone investors sold US bonds in June, with net holdings falling by nearly €6bn. That’s the first net drop in US bond ownership by eurozone investors since 2013.
So you’ve got a strong US economy, rising inflation, and you’ve also got the distortions of the QE era being wound down gradually.
All of that points to a continued rise in bond yields – indeed, it points to a long bond bear market, to follow the long bull market bond investors have enjoyed for the last 30-odd years.
Today’s market has grown too used to easy money
So what are the implications of that? Fundamentally, rising US ten-year bond yields mean interest rates are going up. At a time when global debt levels are even higher than they were before the financial crisis, that has to have an impact.
Rising US bond yields tend to mean a stronger US dollar too. That is bad news for emerging markets. It effectively tightens monetary policy globally, and those with dollar debt but non-dollar income will feel the pain acutely.
In other words, the good times of easy money are starting to recede into the distance. Eventually, markets are going to catch up with that fact and there’s a good chance that it won’t be pretty.
I just read a gobsmacked of a piece in the Wall Street Journal pointing out that more money-losing companies managed to go public in the US this year than at any point since records began in 1980. A full 83% of US IPOs so far this year involved companies that had lost money in the previous 12 months. Before that, the previous peak was in 2000 – at 81%.
That’s incredible. People still think of the tech bubble as being the peak of investor credulity. Maybe it’s no longer true. But if interest rates are rising, then it really can’t last for much longer.
For now, I still think that the biggest beneficiary of a reflationary global economy would be Japan. The Nikkei has been on a tear recently and the stronger dollar is usually good news for Japanese equities too. So make sure you own some Japan.
You might also want to take another look at Tuesday’s Money Morning, where I outlined distressed debt investor Howard Marks’ views on the market cycle, and how corporate debt is likely to be at the centre of the next crash.
A rise in Treasury yields is exactly the sort of event that might make life a lot harder for many of these over-borrowed corporations – and the investors who have queued up to hand over money to them.