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The bond market turmoil: causes and consequences

3/11/2021

In recent months, US government bond yields increased significantly on the back of higher inflation expectations but more recently, higher real rates have been the key driver. The latter development is in turn related to the prospect of massive additional fiscal stimulus. Unsurprisingly, the dynamics in the Treasury market have had global spillover effects, raising concern about an unwanted tightening of financial conditions.

TRANSCRIPT // The bond market turmoil: causes and consequences : March 2021

3 QUESTIONS

FRANÇOIS DOUX

The upturn in long-term rates is a key theme that has been bothering the financial markets since the beginning of the year.

William De Vijlder, hello.

WILLIAM DE VIJLDER

Hello François.

FRANÇOIS DOUX

You have spoken about angry bond markets, and your words were picked up in the press. First question: what is causing the upturn in long-term rates?

WILLIAM DE VIJLDER

Financial market expectations are mainly to blame: inflation is expected to pick up in the months and quarters ahead, and the recovery is also expected to accelerate. Three fundamental factors also come into play: a very accommodating monetary policy, the successful rollout of vaccination campaigns in the United States, and above all, the USD 1.9 trillion rescue plan that is looming on the horizon. Together, these three factors will give the US economy a real boost.

FRANÇOIS DOUX

Indeed, we mainly talk about the US economy, and 30-year Treasury bonds in particular. Second question: what are the short-term consequences of the upturn in the long end?

WILLIAM DE VIJLDER

I would begin by saying the consequences are the same as always. This trend has also affected other bond markets around the world. It is a matter of great importance, notably for the eurozone, where the economic cycle has become desynchronized with regard to the prospects for an economic recovery in the US. At the same time, the financial and bond market cycles are still synchronised. This has triggered several remarks and verbal interventions by the European Central Bank.

There have even been bond market interventions in Australia, since their policy is to target the level of interest rates. The repercussions have been global. As to the United States, however, there is no need to panic. Why? Because inflationary momentum is slow. It should not be exaggerated. There is a limit to how much the yield curve can be expected to steepen in reaction to inflationary fears, or in reaction to expectations of a tightening of US monetary policy.

FRANÇOIS DOUX

My third and final question: what are the medium-term consequences of the upturn in long-term rates? After all, it does signal a decline in bond prices?

WILLIAM DE VIJLDER

This is where things become much more delicate. Indeed, to a certain extent, what we are observing today is rather ironic. For years now, we have been pursuing an extremely accommodating monetary policy in the hopes of boosting inflation. Today, the conditions have finally come together for inflation to pick up. So the markets are beginning to fret. The markets are always worrying about something. For the bond markets, the big worry is “what will the Federal Reserve do next? How will it handle the transition from a very accommodating monetary policy to a more normalised policy? How will it announce the transition?” The Federal Reserve faces a very perilous balancing act and will need to be extremely cautious in all its communications. Why? To avoid creating a shock like the “taper tantrum” of 2013, when the Fed triggered a bond market crisis. Under all circumstances, it must avoid triggering a similar shock, which would have a detrimental impact not only on the financial markets, and of course the stock market, but also on the real economy. The housing market also comes to mind, and the real-estate sector in general, as well as corporate financing conditions.

FRANÇOIS DOUX

US long-term rates remain the key benchmark for the rest of the economy.

WILLIAM DE VIJLDER

That’s right.

FRANÇOIS DOUX

Thank you, William De Vijlder, for this update. We will keep an eye on the evolution of long-term rates. Tune in again in April for another edition of EcoTV.

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