The bond market prefers stability. If it does not get that it will from time to time impose its own sense of market discipline in the form of higher yields.
When policy is all over the place, the bond market begins to price in increased risk, demanding higher compensation for the prospect of shrinking real returns on investments.
In the 13 weeks since the war in Iran began, the yields on 2-year and 5-year Treasury bonds have increased by 64 basis points, closing at 4.0% and 4.14% last Friday.
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Ten-year yields closed at 4.44%, an increase of 50 basis points, while the 30-year rose by 30 basis points to nearly 5%.
The global drawdown of oil reserves and refined-product inventories is entering a period of operational stress. If oil prices pop over the next few weeks, one should anticipate a sharp move higher in bond yields by investors pricing in higher inflation.
The increase in yields at the front end of the curve reflects the prospect of monetary policy tightening in response to higher inflation, a move that will raise the cost for short-term commercial borrowing.
Increased yields at the longer end of the curve reflect the bond market’s concern over the sustainability of government debt that has been incurred in recent years.
The bond market’s displeasure with the prospect of the economy entering a phase of stagflation lite—both higher inflation and slower growth—is seen in distortions in the front end of the yield curve.
Over the past 13 weeks, the bond market has gone from anticipating additional Federal Reserve rate cuts to now expecting monetary policy tightening in response to higher inflation, with the forward market calling for a full rate cut by next April.
Instead of a smooth, upward-sloping yield curve of normal periods of low inflation and sustainable rates of growth, the yield curve has developed kinks, with the 2-year yield anticipating increases in the federal funds rate to 4%, while the kink in the 5-year area reflects the threat of slowing growth.
The takeaway
The bond market in developed economies has a history of signaling its displeasure over unsustainable government policies and imposing market discipline.
The UK bond market selloff of 2022, which famously brought down the government of Prime Minister Liz Truss, is the most recent example of such market-based discipline.
In today’s U.S. economy, the prospect of higher inflation and higher government spending has resulted in distortions at the front of the yield curve as it anticipates rate hikes by the Federal Reserve, while the long end of the curve is in what has become a three-month bond-market selloff.
