Battered bond market braces for a new era of interest rates

The world's largest sovereign bond markets are bracing for their worst month in years as soaring energy costs exacerbate inflation and the AI boom boosts economic growth, leading investors to position for a prolonged era of higher interest rates. Two-year US Treasury yields have jumped almost 60 basis points in September, poised for the biggest monthly rise since early 2023.

Similar surges are expected in two-year borrowing costs in France, Germany, Britain, and Australia, with Japanese government bond yields near multi-decade highs. Societe Generale's head of corporate research for FX and rates, Kenneth Broux, notes that the energy story and inflation story are expected to linger in the short term, prompting bond markets to adjust accordingly.

Some investors view rising yields as attractive for government bonds, while others remain cautious due to concerns about high government debt. October will bring new tests, including US jobs and inflation data, French budget talks, a UK budget, and potential bond issuances from tech firms. Sovereign bond markets are crucial as they influence business and consumer loans, such as mortgages.

If borrowing costs rise too rapidly, it could destabilize financial and economic systems, prompting governments and central banks to closely monitor the situation. Compared to 2022, the speed and high absolute level of global rates now are causing more concern among markets. Home loan rates in the US have reached their highest level in over two years, while 10-year Treasury yields, first above 5% since 2007, are on track for the biggest monthly jump since 2022, with a potential 50 basis point increase.

The ICE BofA MOVE Index, gauging bond-market volatility, has surged nearly 30% in September, the largest rise since March, indicating heightened uncertainty. While some investors sense opportunities, the volatility has caught many off guard. Nonetheless, some, like Lombard Odier Investment Managers' Florian Ielpo, have become more optimistic about government bonds, anticipating persistently higher borrowing costs as the market competes with tech firms' bond sales to fund AI investments.

Despite historical standards, a 5% 10-year rate is not considered excessive by Warburg Pincus CEO Jeffrey Perlman, who believes that deals can still proceed at this level. However, in Europe, French budget negotiations and the UK's first budget under new Finance Minister John Healey will likely keep fiscal challenges in the spotlight.

Political tensions in France have intensified bond moves, with the country's 10-year yield surging over 50 basis points this month, the largest monthly shift since 2022, widening the gap over German Bund yields to the widest since 2012. Nomura senior European economist Andrzej Szczepaniak attributes this to uncertainties about the upcoming French budget and potential non-delivery, as well as the growing popularity of far-left presidential contender Jean-Luc Melenchon in opinion polls.

In the US, the recent rate hike has bolstered the Federal Reserve's anti-inflation efforts, but uncertainty surrounding the outlook and subsequent actions from the Treasury, which has curtailed borrowing costs, remains a concern. Policy uncertainty is coming from both the Federal Reserve and the Treasury, leaving Pictet Asset Management senior multi-asset strategist Arun Sai deeply uneasy about the US policy mix.