Global Bond Market Turmoil

As we enter the new year, the global bond market has been on a turbulent roller coaster ride. This year has seen a significant spike in U.S. Treasury yields, commonly regarded as the "anchor of global asset pricing." Within just four months, the yield on the benchmark 10-year U.S. Treasury bond skyrocketed by over 100 basis points, nearing the psychological threshold of 5%. The last brief breach of this landmark level took place in 2023. Moreover, the yield on the 30-year Treasury bond has also reached 5%, prompting many financial experts on Wall Street to consider this yield rate the new norm.

Taking a closer look at the landscape of international bond markets, yields in the United Kingdom, Japan, Germany, and other countries have followed suit and surged recently. For instance, on January 8, the yield on Britain's 10-year bond climbed to 4.82%, marking the highest level since 2008. Just a day later, Japan's 10-year bond yield increased by one basis point to 1.185%, the highest since May 2011. This trend continued on January 10, as yields from various European countries saw significant rises: France’s bond yield went up by 3.6 basis points to 3.425%, Germany's by 3 basis points to settle at 3.00%, while Italy and Spain recorded increases of 6.1 and 3.6 basis points, respectively.

Investor sentiment toward the global bond market has now taken a more cautious turn as yields continue to climb. According to JP Morgan, several factors including de-globalization, an aging population, and increased spending due to climate change are saying that the 10-year Treasury yield could remain elevated at 4.5% or above for the long term. Peters from PGIM Fixed Income added that if the 10-year yield were to surpass 5% in this environment, it would come as no surprise to him.

Amid these developments, the prospect of an interest rate cut by the U.S. Federal Reserve appears to have diminished significantly. Bloomberg noted that even as the Fed joins other major central banks in cutting rates, U.S. yields are still on the uptrend—a shocking dissonance that is almost unprecedented in history. The Fed, set to begin its rate cut cycle in September 2024, faces challenges in maneuvering due to the resilience of the U.S. economy and persistent inflation, limiting the room for further cuts.

A report released by the U.S. Bureau of Labor Statistics on January 10 reveals that non-farm payroll employment increased by 256,000 in December, far exceeding the expected forecast of 160,000. The unemployment rate dipped to 4.1%, with average hourly earnings growing by 0.3% since November of the previous year. Following this robust employment data, major Wall Street firms have revised their forecasts concerning further rate cuts by the Fed. For instance, Goldman Sachs now predicts only two rate cuts this year, against previous expectations of three, tentatively scheduling reductions in June and December.

Bank of America, which initially anticipated two 25-basis-point rate cuts this year, has now shifted to the outlook that there may not be any cuts, potentially even signaling a rate hike. Meanwhile, Barclays has adjusted its expectations to predict a 25-basis-point cut in June 2025, having earlier indicated two rate cuts in March and June this year. Market sentiment reflects a consensus shift, with the CME Group's "FedWatch" tool suggesting the probability of only one cut this year is now above 60%.

Regarding the fiscal landscape, beyond monetary policy, fiscal policy has become a significant driver shaping the bond market. President-elect Biden's administration is expected to implement tax cuts and bolster infrastructure spending, thereby potentially inflating the federal deficit and raising investor concerns about the sustainability of U.S. debt. According to the Congressional Budget Office, Biden's economic plan could lead to an increase of $7.75 trillion in debt levels above current projections for the fiscal year 2023.

Bloomberg forecasts that by 2034, the debt-to-GDP ratio in the U.S. could reach as high as 132%, a level many market analysts deem unsustainable. Consequently, investment giant PIMCO disclosed that it has grown more conservative regarding long-term U.S. Treasury investments, now favoring short- to medium-term bonds over long-term ones.

Yao Ting Zhao, a strategist for Invesco in the Asia-Pacific region (excluding Japan), shared insights indicating that Biden's proposed tax cuts, while likely to stimulate economic growth, would exacerbate the already critical fiscal position of the U.S. treasury and drive inflation higher. Additionally, tariffs could further sustain elevated levels of inflation. The issue of high government debt and fiscal challenge is not unique to the U.S.; many prominent economies, including South Korea, France, Germany, and the U.K., face similarly pressing budgetary dilemmas.

Currently, the yield on the U.K.’s 30-year bonds is at its highest level since 1998, a reflection of increasing market unease regarding long-term fiscal risk. Analysts point out that Britain’s net public sector borrowing is nearing 100% of GDP, placing substantial constraints on government fiscal policy. The Labour government has promised to boost economic growth over the next five years while gradually reducing the debt-to-GDP ratio; however, the rising bond yields present a significant challenge for these goals.

Michiel Tukker, a senior euro rates strategist at ING, asserts that rising government bond yields could trigger a self-reinforcing feedback loop through increased borrowing costs in budget drafting, further worsening the U.K.'s debt sustainability.

Investors are also increasingly alert to the potential danger of simultaneous declines in both stocks and bonds. Historically, surges in 10-year Treasury bond yields have signaled tumultuous shifts in markets, such as the financial crisis of 2008 and the burst of the internet bubble a decade earlier. Although the ultra-low rates in recent years have allowed some borrowers to secure favorable terms, somewhat cushioning them against the impact of the latest yield increases, there remains the risk of accumulated pressure if these trends persist.

At present, the yield on the S&P 500 is approximately 1 percentage point lower than that of the 10-year Treasury bond—an occurrence not seen since 2002. Morgan Stanley observes that if Treasury yields escalate further, the stock market could face more substantial declines. With the S&P 500's current price-to-earnings ratio around 21.2, up from 18 when the yields reached the 5% mark at the end of 2023, a return to an 18 ratio could drive the S&P 500 down to 4,930 points, a 15% drop from present levels.

Moreover, John Marshall, a derivatives strategist at Goldman Sachs, notes that after the shift in Federal Reserve policy to a hawkish stance on December 18, 2024, the financing spreads saw a dramatic decline, compounded by persistent sell-off pressure in recent futures markets. Current conditions are quite similar to those observed in December 2021, when concerns surrounding monetary policy prompted professional investors to sell-off, leading to a 10-month decline in the S&P index.

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