Why the Bond Market Has Everyone On Edge

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2:04I was going to bring up the portrait of Dorian Gray. Right. The bond market, it has been grabbing headlines and roiling global markets, and everyone seems pretty worried. but the bond market is vast and it is very complicated and to talk about the bond market we need a guide so to help us suss out this moment we have friend of the show john authors opinion columnist at bloomberg john you came on and talked about bonds with us a couple weeks ago and we had to pester you again because the story won't go away no it won't it's a fact of life Bond markets are very powerful in ways that you don't really personally experience immediately in your life, but they really are one of the most powerful influences on the world.

2:53Yeah, I mean, you've called the 10-year Treasury note the most important number in the world, I believe. In world finance. In world finance, yes. This is The Big Take from Bloomberg News. I'm Stacey Vanek-Smith, in for David Gurra and Sarah Holder. Today on the show, Bloomberg columnist John Authors weighs in on the latest with the bond market. How we ended up on this roller coaster, why markets across the globe are feeling the consequences, and how worried should we be?

3:32John, how does the bond market show up in our life? How does it affect us? Well, the key thing for most of us is that it effectively sets the baseline for interest rates on which all other borrowing, frankly, across the world financial system is based. So the closest approach to a risk-free rate that exists over a long period of time would be a long treasury bond. The only way you're not going to get paid is if the U.S. goes bust. And as the U.S. can print its own supply of dollars to do that, that's very unlikely. And that is essentially a bond is essentially a loan. So a 10 year treasury note is essentially a loan that you would give the government.

4:19You'd loan it your money for 10 years. At the end, it would pay you interest on that loan plus your money back. That's the yield. And lately, the yields have been quite high. relatively speaking. They've been rising and rising, which means the U.S. is paying more interest on its loans, which means borrowing is getting more expensive. Yes. What are some of the main reasons why this is happening? Well, the main reasons we could look at are, first of all, there are other people looking to borrow. When you have competitive people asking for your money, offering you an appealing rate that they're very likely to be able to pay to you, then the need becomes greater to offer a higher rate to your creditors.

5:07And that means that the overall bond rate will go up. So in the case of... So competition, essentially. Yes. So at the moment, there is immense competition for lenders money because of the huge buildup for artificial intelligence. Those bonds that are being taken out by the giant companies to build data centers aren't as safe as a 10-year treasury, but they're about as safe as loans are going to get, and they are offering very attractive yields. Then you have the steady move in inflation. So that's reason number two. We've got competition, and reason number two is inflation. Yes. Explain how that gets into the bond market.

5:51So if you're lending over 10 years, you are being promised$10 per year or whatever. And the US being the US, you're going to get those$10 a year. The risk you're taking is that thanks to inflation, those$10 buy you less and less as the years go by. Oh, yeah. Like by the time you get your money back, you can't buy anything. Precisely. So next, there is the issue of how the central bank will respond. Central banks don't set long-term rates. There are some exceptions to that in recent years when central banks have intervened to try to limit long-term rates, but you can set what the overnight rate is going to be for banks if you are a central bank.

6:36This is the federal funds rate. Yes. So that's what the Federal Reserve controls, but that does trickle down quite fast. Yes. Okay. The more you think that rates might have to rise, the rates charged by the central bank, then the phrase you have to keep using in economics, all else equal, you would expect 10-year treasury yields to rise as well. Oh, because the Federal Reserve might raise interest rates to address the inflation. And then another critical issue in this, because again, this all does relate to the world in which we live, is demographics. fix the more people that are of retirement age who might want to sell their bonds that they've taken out to fund their pensions that will tend to mean that there's more selling of bonds going on that will mean all else equal that the when you're selling the price goes down so when the population is aging, which it is in the US and in a much more dramatic fashion in quite a number of other places, you would expect all else equal yields to rise.

7:46You also had an extremely long period when the baby boom generation was sort of working its way through the population like a pig through a python that, you know, this was one of the factors that kept yields falling. It sounds like there are four main reasons that you see. It's kind of like a miasma, I guess. Yes. And then one final point you could add to this, which is the one that garners the greatest attention is ability to pay. In the case of the US, this is a questionable concept because, as I said earlier, they do have the power to print their own money. That said, if you let the deficit run unchecked, it will become more and more necessary to inflate that away, to allow inflation to rise, to make it easier to pay that debt.

8:37And that will be bad for bondholders requiring you to demand a higher yield in the here and now. So there is an ability to pay element there. That is for other governments, and particularly for governments in the emerging world that borrow in dollars rather than in their own currency. That is a far more important element of this. I think our debt hit 40 trillion. That's a lot of money. It's a lot of money. I think debt is a big issue too. And I think it's interesting to think about because if you're a person and you get into this much debt, you're in a very different situation than if you're a country where you can just print money and pay it off.

9:16But when you print all that money. There's so much more money in the system. And then that can create inflation prices start to rise. And this is what ultimately is why people like me spend a lot of time talking about inflation and short term interest rates rather than about default risk, because that is where fiscal irresponsibility will show up in the US. And if you're in a developing country that borrows in dollars, it will show up very directly at the risk that you default. After the break, how the bond sausage gets made. And what could happen if the global sell-off doesn't slow down?

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12:11One point I'd like to make, just because I ran the chart recently, and it's fascinating. We are approaching 5%. That's a 5 % interest on the loans. 5 % yield, which does not sound like much, but is like El Capitan in Bond's world. We topped 5 % from about a day three years ago. Other than that, we haven't been above 5 % for almost 20 years since the very early stages of the global financial crisis. And then as the financial crisis took off, people got scared about all kinds of other debt piled into treasuries. The treasury yield went down. What I think is important to mention, however, is that so we've had two decades, broadly speaking, below 5%.

12:53The four decades before that, again, with only occasional interruptions, we were above 5%. So the entire of the Reagan presidency and almost all of the Clinton presidency were with yields higher than they are now. And both of those presidencies are remembered correctly as having been periods of affluence. You can do perfectly well with a higher cost of money. There were reasons such as inflation was much higher and was only steadily coming under control under Reagan. And Clinton brings the deficit under control and eventually gets yields below 5%. But the pain was terrible. There was so much unemployment.

13:37Yes. John, why is this happening like all over the world at the same time? Part of it is that the US, it is the dog that wags the tail in terms of the financial system. Then there is the issue that over a decade after the global financial crisis, yields could stay very low for a very long time because the economy was very slow, very sluggish. Yields were held at a low level. Everybody gets used to the notion that yields can stay where they are. Everybody gets used to very inexpensive mortgages. Yes. And what you now see following the shock of the pandemic and the inflation wave that followed it is normalization, which can sound Pollyanna-ish.

14:25I don't mean it to be Pollyanna-ish but this is more of a normalisation than a crisis that we're seeing that we've had this very weird period of very low interest rates and there's an old British stand-up comedian's joke that people driving, there were all these three-wheeled cars called Reliant Robins and they were very proud to get a speeding ticket because it proved that they could drive that fast. Like fast enough to get a speeding ticket. Exactly. For two decades, chance would be, wouldn't it be a fine thing if we could actually have inflation of much more than 2 % and we'd have a problem with growth because that was never going to be the issue.

15:02And now we're back to more like normal conditions where if you're not careful, inflation will tip above 3 % or whatever, that it's an issue that you need to worry about again. If we are kind of returning to a new normal, and it's true that even though the rates are relatively high, if you look back over decades, they've been in, you know, taking out a mortgage loan. Bond yields have been in the double digits. We're not near any kind of a long-term record. Why is everybody so worried about it? I mean, last week we got great jobs numbers in the U.S., very surprisingly good. There was a very sort of hawkish speech from Fed Chair Kevin Warsh.

15:43So people felt like maybe they knew where he stood a little more. And the bond markets really seemed to kind of panic. Like, why is there so much worry here? Is it the debt? The single biggest reason, yes, there's just that much more debt outstanding. the impact on the government's borrowing costs and what that might do to the other things it wants to do with its budget becomes that much more significant and also plainly with with the growing worries about inequality when you have a more unequal society where more people think they're being treated unfairly obviously if you raise interest rates it's the poorest people who are going to get hit worst, just as they're also hit worst.

16:27They see their credit card, interest rates go up, they can't get loans. Yeah. So the risk that if you're already worried that people are very unhappy about where capitalismism is at present, higher bond yields give you more reason to worry about what could happen. I'm not predicting revolution here, but I am saying that all else equal, you have more reason to be worried about society, about the future of capitalism if rates keep rising. you know, my hair is now grey and all the rest of it. I can actually remember when rates were higher than this, but I was actually fairly young when they were.

17:04You can be well into your 40s at this point and spent 20 years in finance and not have experience of rates where they are now. And basically, by the time you're into your mid-40s, the people who are right at the top of the tree are about that age, particularly if you're bond trading or whatever. That's not an old person's job. In terms of at a psychological level, this is something which people haven't experienced before. So do we not have anything to worry about? Is the bond market panicking unnecessarily? Can we all just like relax and go about our lives and just know that this is a pretty normal interest rate?

17:43We just have a distorted view and all will be well? Okay. I would kind of agree with that, but I would change the emphasis a little. I'm not sure the bond market is panicking. I think the bond market is still fundamentally, rationally raising higher because it's recognizing that the tectonic plates we've been discussing, demographics, inflation, the quantum of debt, have moved in such a way that rates need to be higher. It's reasonable to expect that for the next few years, yields will steadily rise. That will crimp the returns in the stock market. That will crimp what governments can do. It's not necessarily unhealthy.

18:28Now, if you want to put the Adam Smith, Milton Friedman perspective on this, or Schumpeter in particular, the notion of creative destruction, that's a good thing. Capitalism is about the balance of greed and fear, if you take away the fear through really not charging for money for a long period after the crisis, but leave the greed, you have an uncomfortable mixture. If you bring back the fear, if you actually get some of the companies that are hogging capital, that are not making good profits with it, that are not really able to employ people on a good wage with it, if rates move to a level where they actually ration capital and you do get creative destruction with it, where you get some more of the survival of the fittest.

19:18Separate the wheat from the chaff. Yeah, it's ultimately a crueler but more truly capitalist world, which might ultimately give you a stronger economy. And once you've gone through the pain, it might be a stronger economy for everyone. John Authors, thank you so much. With something like the bond market, you have to call on all the forces, literary and historical. This is why you're our man on bonds, John. Thank you.

19:54This is The Big Take from Bloomberg News. I'm Stacey Vanek-Smith, in for Sarah Holder and David Gurra. To get more from The Big Take and unlimited access to all of Bloomberg.com, subscribe today at Bloomberg.com slash podcast offer. If you like this episode, make sure to follow and review The Big Take wherever you listen to podcasts. It helps people find the show. And thank you for listening. We'll see you tomorrow.

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