For those who navigated the turbulent waters of the early 2000s during the dot-com bubble, it felt like an unending financial apocalypse. Each trading day brought more distress, and over the two-year period from March 24, 2000, to March 24, 2002, the S&P 500 plummeted by nearly 51%. This cataclysmic decline has since become a defining chapter in stock market history, often compared to the Great Depression. Today, we stand witness to yet another seismic shift, this time in the bond market. Just like equity markets, bond markets are proving to be vulnerable to tumultuous fluctuations.
Traditionally, bonds have been perceived as safe havens, providing a stable place to park your money and receive a consistent rate of return without subjecting yourself to the roller-coaster volatility of the stock market. Conventional financial wisdom often advises allocating a percentage of one’s portfolio to bonds based on age, with the rest in equities. For instance, a 70-year-old might be advised to have a portfolio consisting of 70% bonds and 30% equities. However, this strategy now seems to carry more risk than expected. Bond funds like Vanguard Total Bond Market ETF (BND), iShares Core U.S. Aggregate Bond ETF (AGG), and Vanguard Intermediate-Term Corporate Bond ETF (VCIT) have all experienced declines of over 20% in recent years. None of these, though, can compare to the staggering 53.34% drop witnessed in the iShares 20+ Year Treasury Bond ETF (TLT). This makes the bond market’s recent performance worse than the dot-com bubble crash, shaking the perception of bonds as a sanctuary of safety.
It’s no secret that bonds, which were traditionally seen as the more conservative counterparts of equities, have taken a significant hit. But what’s driving this bond market turmoil? Is it due to global economic shifts, central bank decisions, or inflationary pressures? It appears to be a cocktail of these factors, each contributing to the current woes of the bond market.
Rather than blaming the current or past presidents, it’s essential to understand the events that transpired. When the financial crisis struck in 2007, the Federal Reserve took unprecedented measures to support the markets, starting with “Quantitative Easing” (QE). This involved the central bank purchasing billions of dollars’ worth of longer-term bonds to reduce yields. Lower yields encouraged capital to flow out of bonds and into stocks, while also reducing borrowing costs for companies, fostering economic growth and job creation. The Fed’s assets ballooned from just under $900 billion in August 2008 to $2.2 trillion five months later, essentially “printing” money.
These efforts were successful. After three rounds of QE and Operation Twist, unemployment dropped, stock markets surged, and businesses rebounded. However, the Fed continued to buy assets to sustain the momentum. By January 2015, its balance sheet had doubled to an astonishing $4.5 trillion, propelling the equity markets to new heights and marking the longest bull market in US history. Then, the COVID-19 pandemic hit. The Fed’s balance sheet soared from $4.1 trillion to $7.1 trillion between February and June 2020, reaching a peak of $8.9 trillion by 2022.
Basic financial principles indicate that increasing the money supply often leads to inflation. In response, the Fed is now aggressively raising rates to rectify the situation it helped create. Adding to the complexity is the substantial national debt. From 2008 to the present, public government debt has surged from $9 trillion to $33.58 trillion, soon to cross $33.6 trillion. The Treasury Department issues bonds to meet interest payments on this debt. Consequently, they are selling more bonds than ever before, but to attract buyers, they must offer higher yields, causing bond prices to decline. The recent downgrade by Fitch Ratings further eroded confidence in the US’s ability to meet its interest obligations.
In short, yields are likely to continue rising until one of three scenarios unfolds:
- The Fed lowers interest rates, causing the short end of the yield curve to drop. This hinges on a significant decline in inflation, which economists expect to occur around mid-2024.
- A surge in demand for longer-term bonds seems unlikely due to escalating debt levels and the improbable chance of a US default.
- A substantial reduction in the budget and debt by Congress. However, this scenario appears highly unlikely.
With ongoing global conflicts and the government’s propensity to provide financial support to one side of these conflicts, the national debt is poised to keep growing. This, in turn, will lead to more bonds being sold by the Treasury Department, resulting in higher yields. This might be welcome news for those seeking a steady rate of return for a fixed period but a nightmare for investors in bond funds or those looking to sell their bonds before maturity.
Bonds aren’t merely pieces of paper or digital entries; they serve as the backbone of various financial instruments and derivatives. Their influence extends to pension funds, insurance companies, and even the equity markets. A tremor in the bond market can send shockwaves throughout the financial system, as witnessed in the banking sector earlier this year, with failures in Silicon Valley Bank, Signature Bank, and First Republic Bank, driven by the sharp rise in interest rates and significant bond losses.
Market crashes, corrections, and downturns are inherent to the financial landscape. They challenge our resilience, our strategies, and our patience. While the ongoing bond market crisis may appear intimidating, armed with knowledge and a disciplined approach, there is potential not only to weather the storm but also to emerge stronger.
The key is to stay well-informed, maintain diversification, and resist the impulse to act out of panic. Use such moments as opportunities to reassess, recalibrate, and reposition. After all, within the ebb and flow of every market lies a world of potential for those willing to explore it.
Featured Image: Freepik
Author Faith Yakubu