As global financial markets grapple with the possibility of 5% benchmark Treasury yields, the question on investors’ minds: how much worse could it get?
Ten-year US yields, the reference rate for the global cost of capital, are fast closing in on the 5% milestone, a level not seen since the months before markets were swept into the financial crisis of 2008. After stripping out inflation, the yield stands at nearly 2.5%, eroding the lure of virtually every other asset.
The selloff is rekindling memories of past market conflagrations, with some drawing parallels to the 2013 “taper tantrum” that saw Treasury yields soar about 130 basis points in two months. As with many downturns, there’s worry that the rout will feed on itself as traders rush to cut their losses.
More broadly, higher borrowing costs for longer mean financial conditions will tighten even without further action from policymakers.
“Even if rates stabilized at the current level, they are likely to break the economy,” said Marija Veitmane, senior multi-asset strategist for State Street Global Markets. “I am very worried about the outlook for stocks.”
Here’s a look at the pain points in world markets:
The riskiest assets have been the hardest to fall. About $1.5 trillion has been wiped from global stock markets this week and MSCI’s all-country index is now at a six-month low.
One metric that’s under close scrutiny: the equity risk premium. The difference between the earnings yield of the S&P 500 index and the 10-year Treasury yield, it’s a way of gauging the attractiveness of stocks versus other assets.
The equity risk premium now stands near zero, the lowest level in over two decades, implying that stock investors aren’t being rewarded for taking on any additional risk. It’s also significantly lower than the average corporate credit yield, according to analysts at Goldman Sachs.
“Fears of higher yields in the future have forced investors to sell and, no surprise, the crowd runs towards a small door,” said Guillermo Hernandez Sampere, head of trading at asset manager MPPM in Madrid.
While the Treasury rout has grabbed all the attention, especially with the 30-year rate briefly touching 5%, other bonds have also plunged. In all about $1.3 trillion has been shaved off the value of global investment-grade debt since the end of last week, according to Bloomberg’s Global Aggregate index.
The stress is being felt acutely across emerging markets, where the additional yield investors demand to own sovereign dollar bonds compared to Treasuries jumped to a three-month high of almost 9%.
“Investors have suddenly woken up to the realization of higher-for-longer rates, which is more painful than one more hike and then a rate cut,” said Evgenia Molotova, senior investment manager at Pictet Asset Management.
The dollar’s renewed surge — it’s up almost 1% against a basket of Group of 10 rivals this week — is also sowing concern.
When the yen broke 150 per dollar on Tuesday, speculation grew that the Bank of Japan had intervened to prop it up. China and Thailand have resorted to verbal intervention to defend their currencies, while Indonesia’s central bank has also said it’s in the market.
In the longer term, a stronger dollar has big implications for poorer nations because it makes their debt servicing costlier and worsens imported inflation.
“There is not a lot any central bank can do unless we see stabilization at the long end of the US yield curve,” said Peter Kinsella, head of FX strategy at Union Bancaire Privee UBP SA. “The read for me is we will see the dollar trading firm in the fourth quarter. You will see idiosyncratic interventions, which are unlikely to be successful.”
Junk Bond Market
Investors are also closely watching for cracks in the corporate credit market. The Markit iTraxx Crossover index, which tracks credit insurance costs for European junk-rated issuers, climbed above 460 basis points this week for the first time since early May.
The volatility is already causing investors to scrap some deals. The sale of a portfolio of European leveraged loans worth €290 million ($305 million) was pulled on Wednesday due to market conditions, according to people familiar with the matter.