• Bonds are more important than stocks
  • Why are bond yields surging?
  • Higher interest isn’t affordable

The bond market is far more important than the stock market. And yet, it gets a fraction of the attention. That’s despite its power over your mortgage, your government’s fiscal position and the valuations of the stocks you own.

You might also have noticed that the bond market has the power to fire governments like Liz Truss’ – and determine the outcomes of wars like the Napoleonic Wars.

Bonds control government policies, like Greece’s pension payouts. They also set the so-called “risk-free rate” against which all investment returns are benchmarked.

Today, we examine why the recent action in bond markets is something you should be worried about…

In short, the bond yields of governments around the world are high and going higher. They’ve reached the heights of 2008, when unaffordable interest payments triggered a crisis for the ages.

But what do higher yields mean in practice?

Well, the interest that governments must pay to borrow money is set by bond yields. And the returns that investors can get from buying bonds likewise.

It also means that bond prices are falling. This might seem confusing, but it’s equally true for dividend-paying stocks. The lower the share price, the higher the dividend yield you can collect.

Indeed part of the bond market’s power is to offer an alternative to stocks. If bond yields are enticingly high, investors are less willing to take risks in the stock market. That’s why share prices have fallen – the alternative is paying a decent return.

Bond markets are also moving mortgage rates ever higher, putting a squeeze on borrowers.

Companies that borrow money are facing the same squeeze because their bonds are effectively priced relative to government bonds.

It’s the rising tide that sinks all boats, in other words.

But why did bond markets move in the first place?

There are several theories, but the truth is that we just don’t quite know what combination of those theories actually explains the bond market action.

The first theory is inflation. Higher inflation devalues the money that bonds pay, so investors require higher yields to compensate them for this loss.

The higher bond yields are therefore signalling that investors expect inflation to stick around for longer than they had previously anticipated.

This is an important revelation because the cause of our inflation over the past two years – the pandemic and energy shock – is abating. So where is inflation going to come from next, according to the bond market?

Related to this first theory are central bank interest rates. Because central banks conduct their monetary policy via the government bond market, they have an impact on yields there. Higher bond yields signal that markets expect central banks to continue raising interest rates to higher levels than previously expected in order to rein in inflation.

But the story needn’t be all about inflation and central bank action.

The bond market is just one place to put your money. And, in such a game of alternatives, higher bond yields suggest that investors are less interested in owning bonds relative to other possibilities.

This would be good news… if stocks were rising, because it would suggest that optimism about financial markets is driving investors out of the “safe” bond market and into the stock market to try and generate higher returns.

Instead, we have the unusual situation of falling stock and bond prices together – the dangerous combination that made 2022 so bad for investors. It suggests something else must be at work.

Another explanation for higher bond yields is all about governments themselves. Just as riskier corporate borrowers have to pay higher interest on their bonds, so too do riskier governments.

With the US government’s bonds recently being downgraded by another ratings agency, the higher bond yields might be suggesting that lenders are worried about the government’s long-term finances.

Whichever theory you subscribe to when it comes to explaining the bond market’s action, the real question is when the tide turns.

You see, given the amount of debt in the financial system, interest rates are getting dangerously high. This applies to the government budget, to companies that finance themselves using debt and to mortgage borrowers.

At some point, something will snap. Perhaps that has already begun in China.

Either way, once something breaks, many of the theories explaining higher bond yields will suddenly reverse.

People will seek the risk-free status of bonds, regardless of their lower returns. The government’s credit rating will look markedly better than anyone else’s. Inflation will tumble and central banks will cut interest rates.

All of this would be good for government bond prices, creating a rally as investors pile in.

The question is: when will it happen?

Well, the investor who became famous for shorting financial markets in anticipation of the 2008 crisis recently made a whopping $1.6 billion bet that it’ll happen again. More and more central bankers are recommending they stop raising interest rates in case something breaks. And the mortgage cliff of resetting loans is front page news in many of the countries’ news cycles that I follow.

The more the bond market crashes, the more likely its sudden reversal becomes.

If you ask me, this is no time to be in the stock market with a large chunk of your wealth. But that doesn’t mean you can’t benefit from isolated stock surges.

Our star trader, Eoin Treacy, would like to teach you how.

Until next time,

Nick Hubble
Editor, Fortune & Freedom