What the greatest selloff since the Financial Crisis means for the economy and currencies

By the OFX team | 11 October 2023 | 6 minute read

Most people don’t pay too close attention to the bond market – but they should. Thanks to the nightly news, consumers might think equities are the more important barometer. But bonds are the dominant investment market valued at $US130 trillion globally. Share markets, by comparison, are worth $US100 trillion.

Bonds and currencies – an explainer

Share prices are hugely influenced by bond prices. When investment analysts try to value what a company’s shares are worth, they use the return, or yield, on bonds as a key input. In essence, they are trying to work out how much of a premium an investor should get by putting their money into a relatively riskier proposition – a company – than keeping it in a more stable, less risky investment: bonds.

Bond prices and their yields have an inverse relationship. When bond prices go down, the return the bonds pay – the yield – goes up.

It’s not just equity markets that are influenced by bond markets, the entire economy is. Often we think about interest rates as something set exclusively by central banks. They set interest rates monthly (cut, raise or hold) but bond markets operate to the tune of $200 billion per day¹. How bond markets perceive risk, and what they are willing to accept for taking risk is also hugely important.

Bond investors pay for government deficits by lending to governments (federal, state and often municipal). They fund banks and therefore influence mortgage costs and credit card rates, and they fund companies, influencing borrowing capacity.

Currencies, of course, are highly dependent on interest rates, and the flow of money around the world – largely by selling bonds in one denomination and buying them in another – is a factor that causes currencies to rise and fall.

So the recent activity in the bond market is important

The bond market flexes its muscles.

Nobody likes hearing references to the Global Financial Crisis but that’s where things are standing – at least in the US. It’s because bond yields, specifically on US Treasuries, have reached a peak not seen since that era of widespread turmoil.

In the first week of October, the 10-year Treasury yield moved up to 4.89%, its highest level since Oct 2007. 30-year bonds punched through 5% – also the highest since 2007².

Remember, when yields go up, bond prices are going down and bondholders are sitting on the kind of losses not seen since the Financial Crisis. According to Bloomberg, long-dated bonds (10 years or more) have fallen 46% since their peak in March 2020. That is nearly as much as the 49% plunge in US stocks during the dot-com bust in 2001. 30-year bonds have fallen even further, down 53%, which is not far off the 57% plunge in equities during the depths of the financial crisis³.

What’s going on?

One factor is that the US economy has been stronger for longer than expected, despite an unprecedented series of interest rate rises.

Analysts had expected the US economy to slow down significantly, but a bumper jobs report in October⁴ has investors concerned there are more rate hikes to come, and that is keeping bond prices down and yields elevated.

But other factors are also at play that are putting fear into investors and affecting how much they want to be compensated for taking a risk.

The US government is flirting with chaos. For example, Far-right Republicans managed to evict their own Speaker from Congress. Prior to that fiasco, Congress only just averted a government shutdown over US debt levels.

Furthermore, the US federal budget deficit looms large, predicted to reach a staggering $US2 trillion this financial year, amounting to approximately 7% of the country’s GDP. US gross national debt has just topped $33 trillion, and the repayment on that debt is now greater than what it spends on defence⁵. Buyers of US Treasuries will want to be compensated for that excess, especially during political uncertainty.

While investors are worrying about those risk factors the market for US Treasuries is being flooded.

The Federal Reserve is selling off the Treasuries it bought up to create liquidity during the pandemic. China has also been selling US Treasuries, with one analyst suggesting China has sold $300 billion worth of US Treasurys since 2021, with $40 billion sold since April of this year⁶. With more bonds flooding the market, the price of bonds is pushed down and yields rise as a result.

The danger lurking in the bond rout

“If rates continue to rise the way that they’ve been rising, eventually there will be a financial accident, eventually something will break and that will get the Fed moving in the other direction,” David Lebovitz, global market strategist at J.P. Morgan Asset Management told Bloomberg⁷.

We’ve seen a couple of canary-in-the-coalmine events already from rising interest rates, including the collapse of regional US banks. The commercial building market is already in a depressed state thanks to post-pandemic low occupancy rates, and higher interest rates are squeezing owners of underfilled buildings. Delinquency rates for US commercial building loans spiked in May and have tripled so far this year to 5.6%. During the financial crisis, that delinquency rate exceeded 10% but it took more time to get there⁸.

The problem with financial crises is that no one really knows where they start until it is too late. Surging bond yields, for instance, had increased the unrealised losses of US banks on their debt securities by $US140 billion to a new all-time high of $US700 billion, while some of the more exotic financial instruments only get exposed “when the tide goes out”⁹.

According to Bank of America, there’s some $US5.5 trillion of debt held privately, leveraged up to six times its book value. The report suggested that 20% of that debt was “unsustainable”.

The currency effect

The surging US bond yields have contributed to the continued strength of the US dollar. The euro is already flirting with a return to parity as investors chase higher returns¹⁰. Japan’s Yen has similarly been drifting further away from the US dollar – so much so that people think the Bank of Japan may be trying to intervene and prop up the Yen.

Countries may also be forced to raise their interest rates just to prevent the gap between US dollar and their own currencies leading to them ‘importing inflation’. With many commodities priced in US dollars, it costs more to import them in, which flows through to domestic prices. Paradoxically, a financial crisis – that likely originates as a result of US interest rate strength – could also result in a higher US dollar. In times of ‘risk-off’, investors seek the safe haven of the US dollar.

What to watch

Two key outcomes are worth keeping an eye on from this point.

One is the kind of financial disaster that has some market watchers worried. That could be news of a big default in a financial institution that ripples through the global financial system. If that happens, expect a flight to the US dollar and big selloffs in equity markets.

A more benign outcome is the bond market getting so far ahead of the US Federal Reserve by pushing up rates that it acts as a natural dampener on the economy, doing more of the heavy lifting instead of waiting for the Fed to raise rates again. There are signs that may be taking place. For instance, oil prices had been on a tear, rising 30% in the past 3 months toward $100 a barrel on supply cuts by OPEC members. But the bond yield surge sent a new message through the market that a fast slowdown could be on the cards, and oil fell 14% in less than a week.

The world is in a delicate place, and currently financial markets are on alert.

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