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Bond Market Jitters: Financial Crisis Becoming a Possibility? Lombardi Letter 2022-02-25 04:32:03 bond market bonds stock market stocks Federal Reserve The bond market continues to face a significant amount of volatility, given the uncertainty around interest rates. However, the financial world is interconnected, and problems in the bond market could lead to selling in the stock market. Worse, it could even cause a financial crisis. Analysis & Predictions https://www.lombardiletter.com/wp-content/uploads/2022/02/wooden-blocks-with-the-word-bonds-and-coins-2021-08-29-01-12-11-utc-150x150.jpg

Bond Market Jitters: Financial Crisis Becoming a Possibility?

Bond Market

Bond Market Investors Spooked; Yields Surge

Remember this basic fact: the financial system is interconnected. If one asset class faces headwinds, others will feel some sort of a ripple effect. Now, with lots of noise about interest rate hikes, you can’t ignore the bond market.

Investing 101: bond prices are inversely correlated to interest rates. As interest rates go higher, bond prices drop, and as bond prices drop, their yields shoot higher. Think of a bond’s yield as the rate of return an investor would get by holding the bond. Also, bond yields are, in many cases, the basis for how interest rates are set on things like mortgages and car loans.

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The Federal Reserve has said it will raise interest rates. There are expectations that the Fed will hike its rates up to seven times this year alone!

In anticipation of the interest rate hikes, the bond market is trying to front-run. Just look at the yields on 10-year U.S. Treasuries. In late-August 2021, Treasury bonds had yields of 1.25%. Not too long ago, the yields on 10-year U.S. Treasuries reached two percent. This figure might look minimal, but it represents a change of 60% in a matter of a few months.

Ten-year U.S. bonds are considered safe assets. If the yields on these bonds are soaring, it’s a sign that investors are panicking.

Junk Bonds & Corporate Bonds Tumbling

Looking at other types of bonds, it’s very evident that the bond market is spooked.

The chart below plots the yield of high-yield bonds. These bonds are often called “junk bonds,” as the companies that issue this kind of debt have a higher risk of default. Not too long ago, junk bonds were getting gobbled up by investors because low interest rates made them look like great investments.

Now, as interest rates are expected to go higher, high-yield bonds are seeing a massive exodus.

(Source: “ICE BofA US High Yield Index Effective Yield,” Federal Reserve Bank of St. Louis, last accessed February 24, 2022.)

In the investment-grade corporate bond market, we see something very similar: yields surging. The chart below plots the yield on U.S. investment-grade corporate bonds. These bonds are issued by blue-chip companies that have a very low risk of defaulting on their debts.

(Source: “Moody’s Seasoned Aaa Corporate Bond Yield,” Federal Reserve Bank of St. Louis, last accessed February 24, 2022.)

What’s Next for the Financial System?

The bond market is huge, several times the size of the stock market. Given what’s been happening, one must ask: What’s next? Is it possible that other assets will be impacted?

Dear reader, we’re already seeing a significant amount of selling of technology stocks as bond yields soar. Tech stocks are deemed bad investments in a high-yield environment. Some of the high-flying tech stocks of 2020 and 2021 are now down by 50%, 60%, or more from their recent highs.

Even the broad stock market is getting impacted. The S&P 500, for example, is in deep correction territory—down by 14% from its early-2022 highs. Meanwhile, the Nasdaq Composite Index is down by close to 20% from the highs it made in late 2021. Clearly, ripple effects are being felt in assets like stocks, and more selling could follow.

However, I wonder if what we’re seeing in the bond market could cause structural damage in the financial world. By this, I mean the volatility in bonds could cause a financial crisis.

There’s one thing you don’t hear much about in the mainstream media: derivatives. Warren Buffett calls them “weapons of mass financial destruction.” At the end of the third quarter of 2021, $131.8 trillion notional worth of derivatives were backed by interest rates and related products. (Source: “Quarterly Report on Bank Trading and Derivatives Activities: Third Quarter 2021,” Office of the Comptroller of the Currency, last accessed February 24, 2022.)

I will end with this: $131.8 trillion notional worth of derivatives is highly correlated with what happens in the bond market. If just five percent to 10% of these derivatives go in the wrong direction, won’t we have a big mess? It’s likely.

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