March Madness In The Bond Market

The beginning of this year kicked off with a major correction in financial markets. Between rising interest rates and the Russia-Ukraine conflict, there was a lot of uncertainty in the world. Markets hate uncertainty. Investors are always pricing in future events and uncertainty makes it harder to do that.

But with the Fed playing its hand carefully and the war in Ukraine appearing to have a path to a resolution, the dip seems like it has come to an end in March. Risk assets like tech stocks, Bitcoin and equities have all made solid gains in the last month.

On the other hand, we just witnessed one of the wildest months in the bond market in recent years. The drop accelerated in March and capped off the worst quarter in the bond market since 1980. It’s been over 40 years since we've seen such a steep decline in bond prices.

What are bonds & which bond market Am I talking about?

A bond is a contract between an institution that borrows money and a creditor that lends it the money. When you purchase a bond, you are effectively giving a loan to the bond issuer. The bond specifies what interest rate will be paid annually and when the principal amount will be returned. This is called the maturity date.

The bond market is arguably the most important market in the finance world. It is the driver of sentiment and predictor of future economic trends. Bonds are an asset class by themselves that offer less risk than stocks. The bonds I am referring to in this article are US government bonds. National governments borrow money to fund their operations through the bond market.

The yield is the interest rate at which government bonds are being issued. When people refer to the “yield” they're referring to the US Treasury Yield: the effective rate at which the US government is borrowing money. The yield curve is a fancy term for a chart that plots the interest rates for different maturity dates.

When bond prices fall, the yield goes higher. They are negatively correlated. So when demand for bonds decreases, the yield appreciates so it attracts investment. That means the interest rate the government will be paying on their debt will increase, so the cost of servicing that debt also increases.

Since 1980, we have been enjoying a bull market in bonds. For more than 40 years the price of bonds has been steadily rising and the yield steadily declining. Buying a 10-year US government bond in 1980 would've given you a 12% return annually. Buying a 10-year US government bond today would give you a 2% return annually.

The yield has significantly dropped over the last few decades which is another reason why investors opt to put their money in riskier assets like stocks to have a higher return on investment.

Governments have been taking advantage of the rise in bond prices over the last few decades because it allows them to take on more debt at a lower interest rate. Especially over the last couple of years, governments all around the world have been printing money at an unprecedented rate.

But what would happen if the bull market in bonds ends and we see a meaningful rise in treasury yields in the near future? What if we are on the cusp of a bond bear market?

The reason why governments are able to print so much money and stimulate the economy is because of these historically low rates. Once bond prices fall and interest rates rise, it will be incredibly hard to sustain this whole fake economy we are currently living in. The ability to print massive amounts of money has always been taking place with the backdrop of rising bond prices and plummeting yields. That is the common denominator.

Year to date, the Global Bond Index is down 6.6%. When it comes to bonds, losing 6.6% in a quarter is a huge loss. This isn't the stock market where a 5% move in a day is a normal occurrence. We are talking about the value of hundreds of trillions of dollars here. Losing 6.6% in a quarter is a big deal and if that is any indicator of what's to come in the future then we might be facing some big problems in the economy soon.

Politicians have been naive when asked about the risk of falling bond prices. They shrug it off because they know the Fed would come to the rescue if the impossible happened. The moment treasury yields increase significantly to a level the government would have a problem with, the Fed would just step in and buy up as many bonds as they can to suppress treasury yields.

In fact, The Bank of Japan came out this week and announced they will buy unlimited amounts of 10-year Japanese government bonds to keep the yield from going past 0.25%. This basically means the Bank of Japan openly declared they will manipulate their bond market to suppress yields.

We are currently at a major market resistance in US treasury yields. If bond prices keep falling and yields keep rising, they will break a multi-decade trend line which could mean the start of a major bull run for yields. This is major trouble for the US government in the long term. They need yields to be low in order to keep funding their operations at a historically cheap rate.

But as I said earlier, just like what the Bank of Japan is already doing, the Federal Reserve will step in and buy unlimited amounts of bonds until yields can be low again. The Fed has been buying US government bonds for decades now so it's nothing new. But it’s a different precedent when they are buying bonds for the sole reason of keeping yields low.

However, the Fed can't keep buying bonds forever and yields will eventually soar at an absurd pace. If this scenario plays out and we see yields get out of control, it can potentially trigger a vicious domino effect. The US government might default on their debt which would send panic around the world and everyone would start dumping dollars. This would end in a US dollar collapse that would cripple the entire financial system.

So we will have to wait and see. This drop in the bond market may be nothing but another correction in the long-term bull market. It can easily put in a bottom here and start heading higher as it has for the last 40 years. But if the first quarter of this year is any indication of what's to come in the future, then we are witnessing the beginning of the end for the US dollar’s reserve currency status.