Government bond prices collapsed globally, as investors rushed to bet on higher interest rates, after major central banks signaled renewed concern that rising oil prices will trigger an inflation shock.
Three weeks after the start of the war in Iran, the effects caused upward pressure on short-term bond yields, overturning the until recently widely held expectations that central banks would cut interest rates this year to support growth.
The wave of selling was led by the United Kingdom, where the rise in yields recalled to some extent 2022, when the fiscal plans of former prime minister Liz Truss led the debt market to collapse.
The yield on two-year bonds rose by as much as 40 basis points to 4.49%, after the Bank of England stated on Thursday (19/3) that it is ready to act to prevent an acceleration in inflation.
The intensity of the decline eased as the trading day progressed, while long-term bonds remained largely unaffected. However, yields on short-term German securities rose by about 14 basis points, as investors maintained bets that the European Central Bank will raise interest rates at least twice this year.
In the United States, yields on two-year US Treasury bonds rose by 10 basis points to 3.87%, after comments from Federal Reserve chairman Jerome Powell led investors to expect that rates will remain steady throughout the year.
There was a common perception that this would end relatively quickly, said Brij Khurana, portfolio manager at Wellington Management. The fear has now emerged in the market that this may last much longer.
The market decline, which focused mainly on short-duration securities that are more sensitive to changes in monetary policy, highlighted how quickly the global outlook has changed since the United States launched the war against Iran at the end of last month.
Before that, investors expected that the Fed would cut rates twice this year, while the BOE was expected to do the same to support a weakening labor market in the United Kingdom.
However, the war in the Middle East and disruptions in global energy and trade overturned these expectations, as the conflict shows no signs of ending soon.
Oil and natural gas prices rose further on Thursday (19/3), as escalating attacks in the Persian Gulf threatened long-term damage to major energy facilities.
In the United States, although the Fed still forecasts one rate cut of 0.25% this year, markets now consider this scenario unlikely.
This is a wake-up call for the bond market to realize that we are approaching the end of the Fed rate-cutting cycle, said Kevin Flanagan, head of investment strategy at WisdomTree.
Statements by central bankers this week suggest they are primarily focused on upside risks to inflation, even as rising energy prices threaten to slow economic growth.
This stance appears to have strengthened confidence that central banks will ultimately contain consumer prices, leaving long-term bonds relatively stable while short-term ones declined.
Tight monetary policy
The European Central Bank kept interest rates unchanged for the sixth meeting.
However, markets still expect tighter monetary policy within the year to curb inflation, even though its president, Christine Lagarde, also highlighted risks to growth due to the war. ECB policymakers are ready to raise rates even at the next meeting if inflation significantly exceeds the target.
BOE governor Andrew Bailey stated that policy must respond to the risk of more persistent effects on United Kingdom consumer price inflation. Although British bonds recovered from the day’s lows, two-year yields remained higher by more than 30 basis points.
Central banks are beginning to adjust their guidance, moving away from rate cuts and toward increases due to the prospect of higher inflation, said Thierry Wizman of Macquarie Group. So far they are placing more weight on the inflationary impact of the energy shock than on potential effects on unemployment.
The more aggressive stance was also evident in Japan, where yields rose slightly after Bank of Japan governor Kazuo Ueda left open the possibility of a rate hike in April.
In the United States, where the central bank has a dual mandate to protect the labor market and contain inflation, Powell said that further progress in reducing inflation is required before rate cuts resume.
However, the possibility that the Fed will intervene if the economy slows likely limited the extent of the decline in the bond market. Nevertheless, futures contracts no longer price in even a single rate cut for this year.
The market has shifted rate cuts, increasing the likelihood that the Fed may ultimately need to raise rates, said Jack McIntyre of Brandywine Global Investment Management.
The probabilities are small, but not zero.
At the same time, labor market data remain at low levels of hiring and layoffs. In one word, the market is increasingly concerned about stagflation.
What the data show
Government bonds, especially US Treasuries, have long been considered a safe haven during periods of recession, geopolitical crises, and other events that cause market turmoil.
However, examining 300 years of history in the United States and the United Kingdom, the Center for Economic Policy Research found that wars and pandemic-scale crises have severely hit holders of government debt.
Cumulative bond returns in wars and pandemics
Historical data reveal a striking pattern, government bonds have repeatedly generated significant real losses during these extreme periods, wrote Zhengyang Jiang, Hanno Lustig, Stijn Van Nieuwerburgh and Mindy Xiaolan.
In fact, they have performed worse than equities and real estate, which are traditionally considered riskier assets.
This happens because wars typically cause large increases in government spending, on average about 7% of GDP annually in the first four years, while tax increases rarely suffice to cover financing needs.
This finding comes as the United States is waging war with Iran, while national debt has surged to 39 trillion dollars. The Pentagon is requesting more than 200 billion dollars to fund the conflict, according to sources.
According to the study’s data, bondholders suffered average real losses of about 14% in the first four years of wars. The losses were so large that they reduced the real value of total government debt.
And as if that were not enough, cumulative bond returns were more than 20% lower than returns on equities and real estate, the opposite of what usually happens during financial crises or recessions.
Every time there is a major war, a sharp decline in bond performance is observed, wars are always periods of destruction for bondholders, they warned. Similarly, investors suffered large losses in the war against COVID-19.
A key factor in the losses is inflation, as its cumulative rate reaches on average about 20% in the first four years of wars.
In the current United States and Israel conflict with Iran, Treasuries and other government bonds have declined significantly, as rising oil prices strengthen expectations for higher inflation and worsening fiscal deficits.
Since the start of the war three weeks ago, the yield on the 10-year US bond has risen by more than 40 basis points.
However, increased spending is not the only reason inflation hits bonds. According to the study, it is often the result of policy choices aimed at reducing debt without formal default, such as suspending the link to the gold standard.
Another reason is so-called financial repression, meaning policies that keep interest rates artificially low through market interventions, preventing bond yields from keeping pace with inflation.
For example, during World War II, the Federal Reserve implemented yield curve control, capped Treasury rates, and proceeded with massive bond purchases.
The study’s findings are particularly important for US debt today, as Treasuries remain the pillar of the global financial system, with the dollar functioning as the global reserve currency.
This status allows the United States to borrow more cheaply than markets would normally permit. However, interest on US debt is now the fastest-growing component of the budget, already reaching 1 trillion dollars annually.
According to the CEPR, governments face a critical dilemma:
Protecting taxpayers from large fiscal shocks may require shifting part of the burden to bondholders through inflation or financial repression, it states. Economic theory suggests that such policies may be optimal when taxation has strong distortions. However, they reduce the safety of government debt and may increase borrowing costs in the long term if investors price in these risks.
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