While they are usually the relatively boring part of your portfolio, bonds have been financial market troublemakers over the last few weeks. There are likely several contributing factors to bonds’ recent bad boy attitude.
First, the U.S. government has issued over $500,000,000,000 in Treasuries over the last three weeks, boosting the total federal debt from $33,000,000,000,000 to $33,500,000,000,000.
This vast supply of new debt entering the market in a three-week period can drive yields up as the market struggles to find enough buyers. Due to the ongoing and growing annual federal budget deficit, the federal government is likely to continue to issue almost $2,000,000,000,000 of new debt every year for the foreseeable future.
Second, the Federal Reserve continues its monthly efforts to reduce its balance sheet. They are permitting $60,000,000,000 of government bonds to mature every month without purchasing new government bonds.
The Federal Reserve vastly expanded the size of its bond portfolio during the COVID pandemic to keep interest rates artificially low. Their purchases created higher demand for bonds – driving prices higher and interest rates lower. Their portfolio more than doubled from $4,200,000,000,000 to $8,900,000,000,000 in a matter of 2 years.
Thus far the Federal Reserve has successfully reduced its portfolio by $1,000,000,000,000 by letting its bonds mature. However, they likely still have another $4 trillion to $6 trillion to go before they get down to anything resembling normal.
This monthly liquidation will require new buyers to step forward to buy government bonds, and the government may have to pay higher interest rates to make those bonds more attractive.
Third, the future credit worthiness of the U.S. Treasury is under review. On August 1, Fitch Ratings reduced its credit rating on our government debt from AAA to AA+ citing “a steady deterioration in standards of governance.”
The Congressional Budget Office projects that without deficit-reducing measures over the next ten years Congress will overspend its revenue by $20,000,000,000,000 – boosting our federal debt to over $50,000,000,000,000 by 2033. Bond investors may be starting to get a bit squeamish about our ability to pay the annual interest on this debt. The markets express these doubts with higher interest rates to compensate for that risk.
Finally, traders are reassessing the strength of the U.S. economy. While a strong economy is greatly appreciated, bond traders are trying to anticipate when economic weakness will rear its head and force the Federal Reserve to cut interest rates.
Over the last three months, traders have drastically shifted their thinking. This summer they were thinking a recession would be underway by this time of the year and result in interest rate cuts starting in November.
However, the economy has proven stronger for far longer than anyone anticipated. The economy is projected to expand this quarter, which means the soonest a recession is likely to be declared is the middle of 2024. They also know if the economy remains stronger that the Federal Reserve may have a harder time reaching their 2% inflation target.
As traders delay their expectations for a reduction in overnight interest rates, longer-term interest rates naturally rise to compete in future years.
These four causes (and likely a few others) pushing interest rates on government bonds higher creates two domino effects:
- Companies who are issuing bonds must pay higher interest rates. Government bonds are considered the closest thing to risk-free investing when they are held to maturity. Therefore, interest rates on any corporate debt should be higher to compensate for this credit risk – potentially reducing future corporate earnings.
- Higher bond yields can be a headwind for stocks. Some traders will decide they can achieve their overall return targets with less risk by increasing their bond allocation and reducing their stock allocation.
While bonds have been market troublemakers recently, they remain an important part of a diversified portfolio and a source of future return potential. They could even rise in value if the Federal Reserve starts to cut interest rates to boost the economy.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price. Government bonds and Treasury bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.
Quote of the week: Benjamin Graham: “The investor must recognize that there are uncertain and hence speculative elements inherent in any policy he follows – even an all-Government-bond program. He must deal with these uncertainties by a policy of continuous compromise between bonds and common stocks, and by adequate diversification.”