Signals from the debt markets

In my article published on 9th April entitled ‘Surge in Sovereign Bond Yields’, I had explained how the conflict in Iran which erupted in late February had triggered an energy supply shock which drove sovereign bond prices lower as bond yields jumped. At the time, the benchmark 10-year US Treasury yield had risen to 4.45 per cent, the German 10-year Bund yield increased to 3.1 per cent, and the yield on the 10-year Malta Government Stock (MGS) to just above 4.05 per cent.

Over the past few weeks, the surge in yields has not abated due to fears that the energy supply shock will force the Federal Reserve and other central banks to raise interest rates to contain the impact of the higher inflation readings. Although 10-year yields across the main bond markets are marginally above those in early April, the extent of the movements across the bond markets since early April is now mostly evident at the longer end of the yield curve, namely the jump in yields of 30-year sovereign bonds.

It is not a common occurrence for yields across the major sovereign debt markets to move in such a co-ordinated fashion. The bond markets are sending some clear signals to policymakers and investors across the world. In the meantime, equity markets keep moving higher despite the warning signs from the bond market.

Highest 30-year yields in decades

In the US, the 30-year Treasury yield surpassed the 5 per cent  level, reaching a 19-year high of 5.19 per cent  (a level last seen in June 2007 shortly before the global financial crisis). Meanwhile, the benchmark 10-year Treasury yield, which stood at 4.45 per cent in early April has since risen to around 4.6 per cent  (the highest level in a year), having recorded its sharpest weekly increase in six months. Moreover, the 2-year Treasury yield, which is closely tied to expectations of the federal funds rate, has climbed back above 4 per cent.

These movements were also mirrored across the eurozone as the German 30-year Bund yield rose to 3.69 per cent, the highest level since 2011 at the time of the euro sovereign debt crisis.

Likewise, in the UK, the 30-year gilt has climbed to levels not seen since the late 1990’s while the 10-year gilt yield has surged to a post-2008 high of approximately 5.17 per cent. The jump in yields in Britain was not only impacted by the same factors affecting other economies but also due to an escalation of political uncertainty. The UK Prime Minister Keir Starmer was under intense pressure to resign after the poor results of the Labour party in the local elections of 7th May. Several members of parliament called for the resignation of the Prime Minster and the health secretary also resigned in protest.

Additionally, 30-year government bond yields in Japan also reached their highest level ever of above 4 per cent.

As explained in many of my articles over the years, movements in the eurozone debt markets also filter directly into the Malta Government Stock market. The renewed rise in the German Bund yield and those in other member states, sent the 10-year MGS yield marginally higher from the 4.05 per cent  level noted in early April to 4.09 per cent  with the yield on the longest-dated MGS (the bond maturing in 2052) jumping to 4.62 per cent  on 18th May. Given the inverse relationship between prices and yields, the price of the 2.4 per cent  MGS 2052 dropped to 66.45 per cent  on the day.

Energy, inflation and fiscal issues

The factors contributing to the surge in yields are essentially the same as those mentioned in my article in April related to the energy shock and the impact on inflation together with the addition of a renewed focus on fiscal issues.

Effectively, the energy supply shock has not eased due to the persistent tension in the Middle East with the Strait of Hormuz situation still remaining unresolved. The price of oil has remained elevated and the inflationary consequences have started to show up in higher inflation readings in the US and also the eurozone.

Investors are however now not only focusing on inflation reading but also on the trajectory of government finances across the developed world. In the US, the momentum in the rise in government debt has accelerated and the budget deficit is projected to widen further. There are similar concerns surrounding government finances in the UK, France and Japan. Investors are naturally demanding a higher term premium (the additional yield as compensation for lending over longer term horizons) especially in the context of the increase in the supply of government bonds as budget deficits widen.

Central banks change course

In April I noted that during the meeting on 19th March, the European Central Bank had hardened its tone considerably with President Christine Lagarde placing rate hikes back on the table for the first time in over a year and markets anticipating three interest rate increases during 2026. Since then, ECB officials have continued to warn that the energy-driven inflation shock could necessitate tightening in interest rates. Some policymakers also raised the fear of stagflation which is a combination of weak economic growth and rising inflation. Money markets now attach a high probability that the ECB will implement its first rate increase in the coming weeks when the next monetary policy meeting takes place on 10 and 11 June.

In the US, the consensus in early April was that investors had discarded the probability of rate cuts from the Federal Reserve in 2026. On the other hand, the expectation has now shifted considerably with a strong probability of an increase in US interest rates before the end of the year. Several Federal Reserve officials have adopted a more aggressive stance following the higher-than-expected inflation data. The new Federal Reserve chairman Kevin Warsh has also recently been sworn in which adds a further dose of uncertainty given the various factors at play also in the light of the minutes of the last Federal Reserve meeting showing a number of members not supporting the inclusion of an easing bias in the statement.

Equity markets keep reaching fresh record levels following the impressive earnings season in the US and the artificial intelligence revolution which is leading to a remarkable growth in AI spending. This is positively impacting several sectors of the economy, particularly in the US, Japan, and China. While the rapid developments in AI are truly unprecedented compared to other technological developments experienced over recent decades across the stock markets, the strong upward movement in yields in the bond market should not go unnoticed as a renewed hike in interest rates can begin to impact company valuations accordingly.

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