Are the Bond Markets Sending a Signal?
Many market observers have recently turned their attention to the fixed-income markets, as long-term government bond yields have risen to levels not observed in more than two decades. By the end of May, 10-year and 30-year U.S. Treasury yields had risen to levels last seen before the 2008 crisis. Japan’s long-end bond yields also surged to multi-decade highs. Even in Canada, government bond yields hit multi-year highs.
What has driven these moves? Concerns over rising inflation, fuelled by elevated oil prices, and geopolitical uncertainty stemming from the conflict in the Middle East, have prompted a sell-off in global bond markets, helping to push yields higher.
The value of a bond at maturity is fixed when the government issues it. However, inflation reduces the real value of those future payments, making existing bonds less attractive. Because bonds trade in secondary markets, falling prices translate into higher yields. As a result, when governments issue new bonds, they must offer higher yields, which pushes yields up across the curve.
But it is not just renewed inflationary pressure that has weighed on bond markets. Here are three other drivers:
Persistently large government deficits — Government debt in developed economies continues to rise, with limited signs of stabilization. To finance their deficits, governments must issue more bonds. This is particularly notable in the U.S., where borrowing needs remain elevated and defence spending increased amid recent geopolitical tensions. Japan’s debt burden has also risen substantially due to sustained government spending, reaching roughly 248 percent of GDP, the highest globally by this measure.1
Central bank balance sheets — Many central bank balance sheets expanded significantly through quantitative easing to support economies after the Global Financial Crisis of 2008- 09. Central banks are no longer large-scale marginal buyers of government bonds and, in some cases, are actively reducing holdings through quantitative tightening. This represents a structural shift from the period when central bank purchases helped suppress yields and support liquidity conditions.
Investor premiums — Investors are demanding higher term and inflation-risk premiums amid ongoing geopolitical uncertainty. Higher U.S. yields can also attract global capital, putting upward pressure on yields elsewhere and weighing on bond prices globally.
What Does This Mean?
Higher long-term yields have historically weighed on equities through higher discount rates, though that relationship has been less consistent in recent years. So far, equity markets have largely shrugged off the bond market repricing.
Because bond markets anchor borrowing costs, higher yields are pushing consumer lending rates higher. The U.S. 30-year fixed-rate mortgage rate, the key barometer for housing finance, recently surpassed 6.5 percent. In Canada, the five-year yield, which forms the basis for five-year fixed mortgage rates, rose above 3.3 percent, its highest since July 2024. Typical five-year fixed mortgage rates now hover around 4.5 percent, which may feed into the ongoing slowdown in housing activity.
which forms the basis for five-year fixed mortgage rates, rose above 3.3 percent, its highest since July 2024. Typical five-year fixed mortgage rates now hover around 4.5 percent, which may feed into the ongoing slowdown in housing activity.
Complicating matters, elevated inflation has led to concerns that central banks will need to keep interest rates higher for longer, or raise them further, a sharp contrast to earlier in the year when inflation appeared under control and markets had largely priced in rate cuts. This comes on top of a meaningful erosion in purchasing power following years of aggressive fiscal and monetary stimulus, which has further widened the disparities between asset owners and wage earners.
The other problem, of course, is that higher interest rates increase government debt-servicing costs, further expanding deficits and contributing to higher debt levels over time.
What Can Investors Do?
Within a diversified portfolio, having some exposure to assets that behave more resiliently in this environment is important. This may include real assets, businesses with pricing power and companies that generate steady cash flows regardless of inflationary conditions. By contrast, areas of the market reliant on low discount rates face greater pressure, such as high-growth equities, long-duration assets and highly leveraged business models more sensitive to higher interest rates.
One lesson I’ve/we’ve learned from my/our experience in the industry is that bond markets tend to send signals before they are widely acknowledged. When those signals strengthen, it is usually worth paying attention.
1. https://tradingeconomics.com/japan/government-debt-to-gdp
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