U.S. Treasury securities, along with government-bond markets around the world, have been in free fall for much of the past two months. This unprecedented selloff has hammered stocks, triggered a surge in the dollar, and upset markets from Tokyo to Toronto.
But while most of us, including readers of TheStreet, see these sorts of headlines every day, it's not as easy to understand the mechanics behind the moves, the implications they have for global markets and what they actually mean for the average investor and consumer.
With that in mind, we've put together a brief bond-market primer that looks to address three key questions: What's happening, why should you care and what happens next?
We're also adding a bonus section for those specifically interested in what isn't happening. (Trust me, it's worth it!)
1. What's happening?
In short, a meltdown.
Longer-dated bond prices, the most sensitive to interest-rate changes, have fallen some 46% since their early pandemic peak in 2020, according to Bloomberg data. That's the biggest decline on record and a move that matches the 49% drawdown in stocks that followed the tech-market bubble in the early 2000s.
Bond prices move inversely to their yields based on a financial market principle known as the "time value of money."
In short, that theory says that if you were offered $1 today or $1 in 30 days, you'd take the former, and pay less for the latter because you can invest today's dollar for 29 extra days.
If interest rates rise, you make even more over those 29 days, and thus you pay a lot less for that "dollar in 30 days."
A bond, put simply, is just a series of "dollar in 30 days" payments, spread over a number of years. So as rates rise, an investor would pay less for those payments.
And that's essentially what's happening now: The Federal Reserve, in its publicly mandated inflation fight, has over the past 18 months added more than 5 percentage points to benchmark borrowing costs, creating a higher floor for interest rates.
That's forced investors to adjust what they'd pay (much lower prices) for a bond, pushing Treasury yields to multiyear highs.
Inflation in also a key factor in a bond's longer-term performance, as it erodes the present value of a fixed future payment — which, again, is exactly what a bond promises. Inflation, while slowing, is still at levels that require investors to discount what they pay for a bond, pushing prices lower and, you guessed it, yields higher.
A third component is the Federal Reserve itself, which has purchased trillions of dollars in bonds over the decade that followed the global financial crisis (when it needed to push rates below the 0% it could set as a central bank). That move was known as "quantitative easing."
The Fed is now selling a lot of those bonds, in what's known as "quantitative tightening." It expects to dump around $1 trillion a year onto the market – leaving key financial institutions with no choice but to buy them – in an effort to reduce its balance sheet.
That extra supply has been coupled with the additional government borrowing needed to plug record budget deficits. Marshaled by Treasury Secretary Janet Yellen, the U.S. has held larger Treasury bond sales, which have also pushed bond prices lower as investors take down hundreds of billions in new paper every three months.
2. So What?
Financial-market arithmetic (and it's really not much more than arithmetic) is largely an extension of our "time value of money" theory, with a bit of algebra on the side.
Essentially, you can define the value of any financial asset by forecasting the cash flows it will return to you, and then "discounting" those cash flows at a risk-free interest rate.
A bunch of other things go into the formula, of course, but the basis remains the same, be it Apple's (AAPL) -) earnings, coupons on a 10-year Treasury bond or a real estate venture.
Okay, fine, but what's the risk-free rate, you might ask?
U.S. Treasurys.
Uncle Sam's bonds, all $25 trillion of them, perform an incredibly important function in financial markets by providing a proxy for a "risk-free" interest rate that can be applied to any kind of asset.
Now, not everyone agrees with that assessment, and investors are free to discount their cash flows in any way they wish. But Treasury yields are almost always the first basis of any "risk-free rate" discussion.
So when yields rise – and benchmark 10-year notes topped 4.83% earlier this week, the highest since 2007 – the price of all those assets has to fall. Fast.
Back in early July, 10-year notes were pegged at 3.945% and the S&P 500 was trading at 4,450 points. Today, with the same paper at 4.72%, the S&P is set to open at 4,240 points.
It's also worth noting a point that seems obvious but often gets lost in "market selloff" stories: Nothing is solid is a vacuum.
For every investor that dumps a Treasury bond, another must buy it and Treasurys are a fundamental asset class for banks, hedge funds, pension funds, global central banks and a host of investor cohorts around the world. You *have* to own them, in many cases, in order to stay on the right side of regulators.
That means that rising yields (and falling prices) don't reflect concern that the U.S. won't repay its debts, despite the frantic fear-mongering of certain libertarian commentators.
What rising yields do, however, is establish the basis for risk-market valuations (higher yields = lower prices) while at the same time adjusting for inflation prospects, growth projections and a government's fiscal probity.
Treasury yields, then, are a real-time risk barometer that any investor, at any time, can use to gauge overall market sentiment. Others have described Treasurys as a day-to-day referendum on the government.
3. What's next?
The Fed has the unenviable task of keeping inflation as close to 2% as possible, even if it has little control over the components (like food and energy) that influence it the most.
That leaves Chairman Jerome Powell with little choice but to, in popular parlance, "take away the punchbowl," in the form of higher interest rates. This in order to do the one thing it can to tame inflation: slow economic growth without inducing a recession.
So far, it's done well. Last summer, inflation peaked at a multidecade high of 9.1%. Last month, it was pegged at 3.7%, the economy was still growing and the unemployment rate was near the lowest levels in 50 years.
Now, however, with borrowing costs for banks, businesses, and consumers and homebuyers on the rise, many think the Fed's work with rate hikes is largely done as the economy slows and the job market cools, while still largely defying recession fears.
And if elevated Treasury yields are the barometer we've said they are, they're likely reflecting the fact that the Fed will keep its benchmark lending rate (currently set at between 5.25% and 5.5%) in place for a long period, possibly well into next year.
That could also mean we're near the end of the current bond market meltdown, as investors settle on a collective growth and inflation forecast reflected in these high Treasury yields.
Once that's in place (it's never as binary as that, of course, but trading ranges will narrow), investors will have a lot more confidence in returning to risk markets, including stocks, with a stable and predictable "discount rate" in hand.
That, alongside a solid third-quarter earnings season, could spark a rally for the S&P 500 over the final months of the year. That broad-market is currently down 7.1% from its late-July peak.
4. What's not happening
At this point, its probably worth adding a section that debunks one of the mainstream media's (and, sadly, financial media's) assessment of the current market selloff.
Others can disagree, but I am adamant in my view that this is by no means the implosion of a Treasury market bubble.
Bubbles, as they exist in common understanding, occur when an asset (like a stock or a cryptocurrency) delivers less than what it promises. Think tech stocks in the early 2000s, which vowed to change the way we shop, or digital tokens, which backers claimed would undermine traditional finance.
Many of those bubblicious tech stocks no longer exist, and most of those in-vogue digital tokens are effectively worthless.
Treasury bonds can vary in price, of course, and their yields can change by the minute. But the two central promises they carry – that the government will pay you interest on the money it borrows from you and will make you whole when the bonds mature – never deviate.
The U.S. has never, ever defaulted, and it's never missed a coupon payment.
Treasury market bubbles, then, are simply not possible because the government never promised you a locked-in return, only locked-in payments.
Bond investors will have to adjust their portfolio values based on lower prices, but they'll also see the benefit of reinvesting in higher yields.
This offset, while inelegant, is what's known as "duration." It defines the sweet spot when a bond's falling price and its rising reinvestment prospects are equal and opposite.
Duration, in that sense, doesn't exist in stocks (because you can't guarantee that the company you're investing in will always be profitable. But as a Treasury bond investor, you can always rely on the government to pay you back.
That means a loss on a stock portfolio is very different than that of a bond investor. One *could* be permanent. The other *can't* be permanent.
