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.
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