How High Can Bond Yields Go Before Something Breaks?

The US 10-year treasury has risen to 4.97%, UK 10-year gilts have reached 5.3%, and 30-year gilts just below 6%, the highest level since 1998. Oil is hovering over $100, and diesel prices are hitting records in the US. But last week the US Treasury Secretary, Scott Besant, dared traders to bet against him. Now he was talking about the yen, which he has been spending American money to prop up. I'm the house now, he said, and you can bet against me if you want. Now so far nobody has really taken that bet on the yen, but they have been taking it elsewhere. Now Besant, of all people, should know how this tends to go. In 1992 he was working for George Soros when Soros broke the Bank of England's defence of the pound. Governments can try Now from some perspective, in 1981 bond yields hit 15%, and against that 5% looks relatively modest. But it also means it could have much further to rise. But the difference is that debt is now far higher, and growth also much lower. And that means that 5% today could hurt almost as much as 15% did back then. So how worried should we be? Now currently we are experiencing both a rise in oil prices and bond yields at the same time. The selloff in bonds last week was mostly in response to further disruption in oil supplies in the Middle East. With Hormuz mostly blocked, the East-West pipeline is a vital alternative. But now it has been struck by rebels, and Bab el-Mandeeb is becoming another choke point. But these constraints in the oil market all come at a time of falling oil inventories, and a real shortage of diesel and jet fuel. For motorists, the pain is already here, with diesel prices hitting a nominal record in the US. And the UK is now tasked to face both rising oil and gas prices, which of course will push up household bills. And with economic growth actually stronger than expected, it's now more likely the Bank of England will raise rates like Central Bank will around the world. But the rise in bond yields is definitely a global phenomenon. And you can see all major countries are experiencing a similar rise in bond yields. But arguably there is a difference. As Robin Brooks points out, countries with higher debt levels are seeing faster rises in bond yields, whereas countries with lower debt, lower rises. And the biggest rise is for long-dated 30-year bond yields. Basically, at least part of the reason for rising yields are market concerns over fiscal sustainability in the long term. Now I should point out this is disputed. Someone like Paul Krugman argues the rise in bond yields is not primarily due to fiscal dysfunction. He says there's nothing special about, say, the rise in long-term US bond yields. He points out they were higher in the 1990s, despite lower inflation and a budget surplus. But bond yields are rising, and the question is what might break first? Well, government spending plans. US debt interest payments as a share of GDP are now exceeding levels of 1991 and are forecast to keep rising. But unlike the 1980s, economies face a structural increase in borrowing due to lower economic growth and higher debt. And this graph shows a very important changeover. Debt interest payments are growing faster than the rate of economic growth. But look at the projection for US debt over the coming years. And this is why a rise in bond yields could break a government's ability to pay for things like social security. And you can see already the UK has debt interest payments substantially higher than defence, and pretty much equal to the education budget. Governments were borrowing on the premise that yields would stay low. They hadn't planned for this rise in yields. And if interest rate costs continue to rise further as expected, then you have to take that money from elsewhere, which is a political problem as well as an economic one. Now, rising bond yields isn't just about government debt. It is also about an AI boom, or if you prefer, an AI bubble. You can see here there's a sharp rise in private investment in IT. And this is now being financed by borrowing on corporate bond markets. JP Morgan found the six AI companies are borrowing $320 billion via the bond market. That's equivalent to 68% of a new long duration US treasury borrowing. And this surge in private borrowing is causing interest rates spreads on AI investment to rise. But the important thing is that it's creating competition for government bonds. And this pushes up bond yields because investors can choose either corporate AI bonds paying a higher interest or government. And so the government have to pay higher interest to attract enough people to buy them. Now, it's all an unfortunate confluence of factors. So does this mean that we are losing control of the bond market? Well, to give a historical context, this graph shows the golden rule that treasury yields should equal the moving 10-year average for nominal growth. So when inflation leads to higher nominal growth, bond yields rise. And this graph suggests that bond yields are exactly where they should be. But what happens if governments need to spend more on defence, pensions and healthcare, but interest rate costs make it impossible? Well, one option is to create currency and buy back their own debt, just like the US has done in a limited way in recent weeks. Now, this raises scope for debt to be inflated away, causing bondholders to lose out. And look at the mid 1970s, yields were kept lower than nominal GDP growth, lower than inflation, and bondholders lost out. The government were able to reduce the debt burden through inflation, a hidden tax on bondholders. And the question is, at what point do governments have the temptation to try the same solution? And it's not just the government. When bond yields rise, bond prices fall. A 1% rise in yields cuts the price of a 10-year gilt by 7% and a 30-year gilt by 13%. And this fall in bond prices can reduce the value of your pension. Remember when UK yields spiked in 2022, pension funds came under severe strain as the value of their bond holdings collapsed, forcing the Bank of England to intervene. Now, the impact is less rapid, but it's coming from the same direction. The only caveat is that if you want to invest in high-yielding assets, the rise in bond yields is good for those savers. Now, a more direct impact is to housing costs. US 30-year mortgage rates are closely linked to 10-year bond yields. But mortgage rates are now rising at a time when house prices are much higher. And this is causing a frozen housing market in the US and the risk of a house price slide. Now, in the UK, mortgage rates have not risen by as much as the US because mortgage rates are more linked to the Bank of England base rate. But in the UK, rates could well be rising in the coming months if inflationary pressures continue. And don't forget that someone who got a five-year fixed rate mortgage of 1.3% back in 2021, they will now be facing a big jump in mortgage costs. For a 200,000 mortgaging, remortgaging to 5.66%, that could be an extra £470 a month. And already house prices have slid in the past few years, at least in real terms. And recent news puts more upward pressure on interest rates and risks a further slide in real house prices. Now, a really good question to ask is, do rising bond yields end in recession? Well, this graph shows the correlation between bond yields and recession. The years of recession are shaded in grey. Since the 1960s, rising bond yields have often occurred during recessions, at least in the 1970s. And in recent decades, a recession has often occurred a year and a half after the peak in bond yields. But the current situation, rising bond yields, rising oil prices, is perhaps more reminiscent of the 1970s because a standout feature is that confluence of problems at once, rising yields, rising inflation. So the problem is perhaps not really bond yields, but what is causing it to go up. And this graphic from Bloomberg suggests that rising yields have many factors, but the fiscal drivers are becoming more important. Now, it is worth pointing out another perspective. Bond yields are rising due to short-term inflation, the AI bubble, longer-term fiscal issues. But if rising interest rates were to push the economy into an economic slowdown and recession, then almost certainly you would see bond yields come down. There is a self-correcting mechanism. Equally, the AI bubble does seem unsustainable, even if the tech bros are looking for an off-ramp for levels of investment. But if the AI bubble were to burst, again, you would expect to see yields come down. But historically, yields do rise until something breaks. But this breaking point is lower now because debt is higher. So at least in the short term, rising yields will cause real economic pain, especially for governments who have to pay the higher debt interest payments. And the really interesting question is, what happens next? Will advanced economies be tempted to allow inflation to creep up rather than, say, hike interest rates to slow down the economy? Central bankers have a lot of difficult decisions in the coming months, and it depends a lot what happens in the Middle East. Anyway, thanks for watching. Do subscribe, and there will be more videos coming very soon. Interesting times, if nothing else.