Crash Alert: What UK Bond Prices Chaos Means for US Investors
The United Kingdom’s recent gilt crisis may well be the setup before the punchline that is a U.S. bond collapse. Indeed, with U.K. bond prices finally recovering from their recent selloff, U.S. Treasuries have stolen the limelight.
While U.S. equity markets have seen no shortage of action this year with sky-high inflation and rapidly rising interest rates continuing to wreak havoc on investors’ collective portfolios, recently, bonds are the talk of Wall Street. Many long-duration Treasuries are fighting brutal losses this year, especially bizarre given their history as a low-risk investment option and typically have an inverse relationship with stocks. Some bond indices are down even more than the S&P 500, which has flirted with a bear market through most of the year.
By most accounts, U.S. bonds are on track for their worst year ever. Treasuries are an important indicator of investor sentiment and economic strength. Understanding what’s happening overseas may well offer insight into what may transpire in domestic Treasury markets.
What’s Up With the U.K. Bond Market?
The United Kingdom is currently attempting damage control after something of a Treasury crisis in its “gilt” system. Gilts are essentially U.K. bonds, and they recently experienced a tectonic shift. The Bank of England (BOE) was been forced into an emergency intervention in the gilt market, purchasing billions of pounds of long-duration gilts over the past few weeks to stabilize the market as it underwent a historic selloff.
After announcing potentially inflation-inducing tax cuts in the country, investors began rapidly abandoning their positions in long-duration bonds. U.K. 30-year government bonds climbed from 3% in September, to over 5% as investors considered the inflationary impact of additional tax cuts. Bond yields move in the opposite direction of bond prices, reflecting the fact that a number of major British pension funds were offloading their holding of bonds. England pension funds are highly sensitive to sharp changes in lending rates due to exposure to gilts via derivatives. As gilt prices fell, fund managers were forced to sell off their positions in order to pay collateral costs, pushing yields up even further.
To stop the spiral, the BOE was forced to step in and purchase gilts in order to prevent a further bond collapse, which would put undo pressure on lending rates. As a result, on Sept. 28 the BOE announced it approved as much as 65 billion pounds to purchase gilts as necessary through Oct. 14, now extended through the end of October. In fact, UK leadership, as part of the effort to stabilize the gilt market, announced last week it would be scrapping the previously announced tax cuts.
Global bond markets, perhaps more so than any other investment vehicle, are closely intertwined. It’s no coincidence that just as the U.K. announced its bond-buying program, U.S. treasury yields fell.
With that in mind, what’s been going on with U.S. Treasuries?
U.S. Bond Prices Sink as Yield Curve Inversion Looms Large
The U.K. isn’t the only country with bond issues lately. U.S. Treasuries are undergoing a historic selloff, with some long-duration bonds falling more than 33% this year. Paired with recent yield curve inversions, a well-cited recession indicator, there’s more weirdness with bonds than meets the eye.
Bonds and stocks usually move in opposite directions. As market fears push investors out of the comparably riskier stock market, bond prices tend to rise as investors jump on the low-risk guaranteed return of fixed-income investments. This year, however, some long-duration bonds have fallen alongside stocks, in some cases even outpacing equities. For context, the last time both bonds didn’t go up when stocks fell, was 1969.
Unfortunately, this is only the tip of the iceberg when it comes to the bizarro bond market. Inverting yield spreads are perhaps an even more frightening condition.
Under normal conditions, longer-term bonds should always offer higher returns than short ones. You’re essentially letting the government hold onto your money for a longer period without repayment, it makes sense to earn a greater interest payoff. This year, though, shorter-term Treasuries have, on several occasions offered higher yields than longer-term counterparts, in what’s known as a yield curve inversion. The most common yield spread most investors watch is between the 10-year and 2-year Treasuries.
Yield curve inversions are considered black swans in the financial world, consistently preceding the last seven recessions within 19 months. At the time of writing, the U.S. 2-year Treasury offers a 4.4% return compared to the 10-year’s 4.09% yield. This may be a startling sign that the effects of this year’s Fed-induced bear market may only be in its infancy.
On the date of publication, Shrey Dua did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.