Bonds spell fear for grandees of world of finance

Bond yields. For the grandees of the world of finance gathering in Marrakech for the annual meetings of the International Monetary Fund and World Bank, that is the one overriding issue. 

The surge in bond yields over the past couple of months changes everything: the outlook for the world economy, the chance of some financial institutions collapsing, the national finances of just about every country, mortgage rates, the lot.

Last week, the 30-year US Treasury bond yield climbed above 5 per cent for the first time since 2007, while the 10-year rate, just under that level, is also at its highest since before the banking crash.

So the world’s biggest borrower, the US government, is having to pay more to get people to lend it money than it has at any stage in the past 15 years. If rates go to 6 per cent, as some in the market expect, it will be paying the highest rate this century.

That affects everyone, for the world is awash with debt. It will obviously put all borrowers under strain, along with the entire global financial system. When that happens, it is hard to spot in advance which parts of that system will crack. Warren Buffett, the veteran American investment billionaire, put it pithily: ‘Only when the tide goes out do you discover who’s been swimming naked.’

So where might the pressures break out? There are some obvious possibilities. One is that the US economy will be tipped into recession. It is still remarkably strong, despite all that has been thrown at it, and we will see what the economists at the IMF think.

But I would trust the judgment of Mohamed El-Erian, who was head of Pimco, the giant American bond management enterprise. He now thinks that the combination of this rise in yields and the upward tilt in inflation make US recession much more likely, and he notes that mortgage rates are at their highest for 23 years.

Sovereign debt problems are another weak link. Our own ten-year gilts now yield more than 4.6 per cent. That is well below US rates but higher than a year ago at the peak of the furore over the Truss/Kwarteng emergency Budget. You don’t need to be good at maths to work out that more spent servicing the national debt is cash not available for tax cuts.

Some other countries are in worse shape. Italy’s national debt is 145 per cent of gross domestic product (ours is just under 100 per cent) and its ten-yield bond rate went above 5 per cent in trading this week. The equivalent French debt is yielding 3.5 per cent, which may not sound bad, but is at its highest since 2011.

Most financial institutions are prepared for this. This is what ‘stress-testing’ is about. But some won’t be, and in any case there will be a general damping impact across the world economy.

As for investors, well, we saw last year that many UK pension funds were blind-sided by the surge in gilt yields. So much for gilts being officially classified as low-risk and the funds in effect being required to hold them.

The same goes for US government debt. If you happened to have bought 30-year Treasuries in spring last year you would have lost half your money. That is as bad as buying equities at the top of the dot-com bubble in 2000. Actually, I have long felt that equities, particularly in undervalued markets such as the UK, are inherently safer than all fixed-interest securities, including gilts.

There is, however, one disagreeable possible outcome for equities. It is that they will be damaged by the mayhem in fixed-interest markets. There are two things here. The first is that if there is indeed a recession in the US, it will have an impact across the world economy. That will lower corporate earnings, a potential decline not currently priced into US equities, including the big-cap giants.

So there will be an economic rationale for lower share prices, something that a lot of the American equity strategists had been forecasting earlier this year.

The other is if investors need, for whatever reason, to raise cash and don’t want to crystallise losses on their fixed-interest portfolios, they will sell down some of their equity holdings (on which they still have decent profits) instead.

Don’t make too much of it, but it is worth just remembering that October is the classic month for big, sudden sell-offs in equities.

It is sunny in Marrakech, with a forecast of 37C this week, but if you are running a nation’s budget or a financial services company, you know the winds are likely to be chilly when you get back home.