Could the bond market sell-off create wider problems?

“A bond market sell-off has driven US Treasury yields to multi-year highs, fuelled by fears of rising interest rates amid stronger-than-expected US economic data. The situation has been further exacerbated by a rapidly expanding US budget deficit, funded through additional Treasury issuance and pushing yields higher (particularly on shorter-dated bonds). The current sell-off may even have been significant enough to break US 30-year Treasury yields out of a long-run trading range – previously apparently a well-entrenched downward trend. 30-year Treasury yields reached almost 3.4% on Friday.

“Sharp rises in yields can cause market dislocations, and if the current bond market sell-off becomes more aggressive, it could begin to create genuine problems for equity markets. This is because, first, investors would be less willing to take on equity risk if they could receive a similar return on US government debt whilst taking zero risk, and second because a rise in the long-term cost of money would lower equity valuations today (under discounted future cashflow modelling).

“If yields in the US continue to rise significantly, this could also begin to impact the wider economy through higher debt refinancing costs, as well as impacting the housing market (banks charge higher interest rates for mortgages when Treasury yields rise).

“For now, though, higher yields are a sign of economic strength in the US and should therefore be viewed in a positive light. We are positioned for rising yields so are comfortable with developments but, as ever, we will be listening closely should the mood music change.”

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David Absolon, investment director at Heartwood Investment Management

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