Bond ructions point to new danger zone in markets

Sell-offs of this scale and speed have the potential to light fires in other parts of the financial system.

One of the enduring mysteries in financial markets right now is why they have been so bulletproof. Stocks, currencies and corporate bonds have weathered a series of shocks, from a worst-case-scenario Middle East energy squeeze to rogue and potentially deadly robots.

This resilience is very welcome, but also very odd. We were all led to believe it was central banks that put markets to sleep after the financial crisis, that their bond-buying programmes aimed at rekindling major economies were dulling the effect of every shock and shoving unwilling investors into risky assets. But now those bond-buying programmes are in reverse, and we still have had the same dynamic.

This week’s violent moves in the government bond markets bring with them the potential to spoil the mood, though. Even in itself, the scale and speed of the shake-up stemming from the US is something to behold. Government bonds globally have been feeling the pinch for months, and we can all argue about the true reasons for that, but it is some combination of oil-driven inflation, a spicy US economy that demands higher interest rates to tap on the brakes, and runaway borrowing. Plus, governments now face some competition for investors’ affections — from hyperscaler tech companies issuing their own debt.

All of this is very familiar to market professionals, but this week, something snapped. The gentle but persistent pressure on bond prices, which cranks up yields on bonds and borrowing costs for us all, turned into a gut punch. The benchmark 10-year US government bond yield — hands-down the most important number in global finance — vaulted above 5 per cent, a space it has not occupied since 2007. At one point this week, it rattled up to 5.22 per cent, more than a full percentage point above where it started the year. To normies, this may not sound like much. To bond investors, it is the end of times.

Two things are important here: the speed and the level. The pace at which those US yields ripped above 5 per cent was unnatural and comparable in recent years only with the short but brutal market shock from Donald Trump’s “liberation day” tariffs in April last year. Nothing disastrous had happened — just an upbeat release of business survey data. But with a bang, yields rushed higher.

Market insiders say this was a sign of distress. Speculative funds now play a crucial role in keeping the bond market ticking — a vulnerability that the New York branch of the Federal Reserve warned about earlier this month. Many clearly did not see the move in yields coming and rushed to the exits.

We have had a dress rehearsal for this before, in the smaller UK and European debt markets, when hedge funds were blindsided by the war in Iran and had to run out of bets on interest rate cuts and into bets on rises. In Treasuries, though, this is exceptionally rare, and it raises the prospect of ugly knock-on effects.

“We’re in the danger zone,” said Derek Halpenny, an analyst at MUFG. Hedge fund managers and other types of speculators whacked by the turmoil may now need to offload entirely unrelated bets to keep the lights on and meet redemption requests. We can only guess at what those unrelated bets might be, but there is a risk of a pullback in carry trades, broadly defined as anything funded in a cheap currency like the yen and churned into investments elsewhere ranging from tech stocks to emerging-market currencies. We could well be “on the cusp” of the shakeout in bonds finally catching up with currencies and other asset classes, Halpenny said.

These are the kinds of hidden threads in markets that keep risk managers awake at night. You never know where they will snap until funds get run over.

The second issue is the level that Treasury bond yields have now reached, this is a serious problem, but mostly not for the US itself. The American economy is motoring along handily — and it has pretty high inflation, which softens the edges of national debt burdens. The higher borrowing costs hurt, for sure, but the US can probably handle this.

The same is not so true for other high-debt major economies with much slower growth such as the UK and France, where debt costs are still determined to a large extent by the bigger, badder US market. The UK is now wheeling into Budget season (yes, again), with benchmark borrowing around 5.4 per cent — a problem not entirely of its own making that acts as a constraint on political choices.

Meanwhile, France is heading into elections next year with 10-year bond yields of 4.67 per cent, more than a full percentage point above Germany’s — an alarming sign of fragmentation that brings veterans of the 2010s Eurozone debt crisis out in cold sweats.

Big stock indices will probably ride out this week’s Treasuries shock. Scorching corporate earnings and the dazzling AI trade have picked up where the central banks left off in supporting equities. Investors might feel something is wrong here but also see no reason for it to end. But bond-market breakouts have a habit of igniting fires in places that are hard to spot. Time to keep eyes peeled.

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