Bond market rout puts global economy on financial crisis 'trajectory'

Inflation rates in Australia and other countries are not decreasing as anticipated, causing significant concern for the global economy and asset prices. If inflation remains high, interest rates may need to either increase or stay persistently high for borrowers. Rising interest rates could lead to a decline in asset prices, such as property and shares, resulting in an Australian recession.

The bond market, which indicates the level of risk in IOUs, provides a glimpse into this dire situation. The Australian 10-year government bond interest rate is near a 15-year high, and it may rise further. Similarly, US 10-year government bonds have hit their highest levels since the global financial crisis. This growing wariness among investors about lending to supposedly reliable borrowers, such as major Western governments, is exerting immense pressure on financial markets and the economy.

Author and former banker Satyajit Das refers to the US economy as the key stress point for the global bond market. Large financial entities are already reducing their exposure to the US market. The Reserve Bank of Australia recently decreased its holdings of US dollars in its foreign reserves portfolio by 10%, bringing it back to 2012 levels.

Deutsche Bank's macro strategist and former Reserve Bank economist, Lachlan Dynan, suggests that US dollar reserves and Treasuries may have lost some of their previously exceptional appeal, particularly due to the strained US fiscal position, which has raised concerns about the usability of US dollar reserves for intervention. The central bank of the Netherlands has also removed a large amount of its gold reserves from the United States and Canada, citing the need to enhance the country's crisis preparedness amid increasing geopolitical unrest.

Norway's $2.3 trillion sovereign wealth fund manager is considering reducing its exposure to US Treasuries from 70% to 50% of its total bond holdings, with a significant portion of the cut being US Treasuries. Other nations, including China, Brazil, India, and Japan, have also decreased their investment in US government bonds. This trend is contributing to an ongoing bond market rout, which is driving interest rates higher.

The interest rate on a bond moves inversely to its price, so when the bond price falls, the yield, or interest return from it, rises. The recent US Treasury Secretary Scott Bessent's announcement to double the US Treasury's repurchase of bonds with maturities between 10 and 30 years to $4 billion aimed to lower long-term interest rates.

However, his attempt to alleviate bond market concerns only intensified them. Rising military tensions in Iran and the subsequent surge in oil prices above $90 a barrel have further exacerbated the situation, making it difficult for US efforts to lower bond interest rates. Dr. Shane Oliver, Chief Economist at AMP, states that unless the US budget deficit is reduced, improving fundamentals will not be sufficient to halt the bond market decline.

Dr. Oliver believes that the bond market rout, driven by structural forces such as the AI investment boom, defense spending, the net zero carbon economy, infrastructure requirements, and lack of fiscal discipline, will continue to push interest rates higher.