The bull market is on borrowed time as interest rates rise

Fed chairman Jerome Powell © Getty Images
Fed chairman Jerome Powell: still bullish

“Who said Octobers in mid-term years were good” for Wall Street? asks Randall W Forsyth in Barron’s. The yield on the US ten-year Treasury bond has jumped to 3.2% as prices have slipped. This is the yield’s highest level since 2011, and it represents a jump from 2.4% at the end of 2017. The spike came in the wake of yet more strong economic data – GDP expanded at an annual rate of 4.3% in the second quarter. Meanwhile, the unemployment rate was at its lowest level since 1969. “It’s a remarkably positive set of economic circumstances,” according to Federal Reserve chairman Jerome Powell. “And there’s no reason to think it can’t continue for quite some time.”

But if the US economy is that strong, then “why are there widespread concerns America’s financial markets could soon collapse?” asks Liam Halligan in The Sunday Telegraph. The reason is that we’re still in a “post-crash Alice-in-Wonderland world” where “good news is bad news”.

Signs of economic strength mean central banks could curtail their ultra-loose monetary policy sooner rather than later. “That, in turn, spooks financial markets – bloated after years of interest rates nailed to the floor and having gorged on the drip-feed stimulant that is quantitative easing.” Given investors have borrowed heavily since 2008, financial markets are now highly “leveraged”.

Global impact

The US is the world’s most important economy and the interest rates at which the US government can borrow over a certain period – represented by the bond yields – set the tone for markets worldwide. In addition, higher US yields strengthen the dollar as the yields on US assets become more appealing. That “exacerbates the developing headwinds for US earnings”, according to Morgan Stanley, and it will worsen the squeeze on emerging markets, which always suffer as money leaves risky assets and returns to the US.

The current bond sell-off may be just a technical “blip”, argue Robin Wigglesworth and Kate Beioley in the Financial Times. Two technical factors probably contributed to the turbulence this week. “US companies hoovered up long-duration bonds ahead of a tax break that expired in mid-September and demand fell after the deadline passed. At the same time, a jump in the cost of hedging dollar exposure (a result of short-term US rate hikes) has meant that US debt is now far less attractive to overseas buyers.

Beware inflation

Yet the medium-term trend is clear, as Halligan points out. More Fed rate rises amid a strong economy will raise long-term rates, depressing bond prices and undermining confidence in stocks as dearer money makes corporate debt pricier and hampers earnings. And look out for a sharp jump in US inflation now wage pressures are rising – witness Amazon’s big wage increase last week. Rising prices would imply unexpectedly rapid interest-rate increases to squeeze out inflation, giving the overleveraged world economy a very nasty surprise.