Opinion: What the crash in the bond markets means for the rest of us

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Traders work on the New York Stock Exchange floor in New York City, on Sept. 5.Ted Shaffrey/The Associated Press

John Rapley is a political economist at the University of Cambridge and the managing director of Seaford Macro.

Bond markets aren’t like supermarkets, where the grocer sets the price and you take it or leave it. They operate more like village markets, where you haggle over everything. If, say, a one-year $100 bond offers $105 on maturity – a five per cent return – a buyer who won’t take less than six per cent can simply offer to purchase it for $99. If no other buyer beats that offer, the government has to take the lower price.

That’s been going on for a while now, but things took off recently. For example, while the Canadian government now offers an interest rate of 2.75 per cent on its 10-year bond, investors have knocked its price down so far that the effective yield rose above four per cent last week. (Bond prices and yields have an inverse relationship.)

It’s the same elsewhere. Across developed economies bonds have fallen, the decline in the price of U.S. Treasury bonds having become so steep that it now ranks among the worst crashes in history.

Some analysts think the bottom is now in. Bonds began rallying this week, in part because the outbreak of war in the Middle East drove investors into the safe haven of government paper, but also because some took heart from recent statements by U.S. Federal Reserve officials, suggesting that the rise in bond rates meant they didn’t need to tighten policy any further.

But I wouldn’t bet on this being more than a bear-market rally. Because of factors including developed countries’ growing debt and a slowing Chinese economy, the long-term trend may still favour lower demand for Western government bonds.

Besides, as reports this week out of the U.S. showed, the inflation declines may now be levelling off at a point that still exceeds central bank targets. They may not be ready to declare the war on inflation won. That could mean further falls in bond prices and rising yields. Sooner or later, that will affect all of us.

Since the government competes with banks to attract loans, rising interest on its debt filters right through the economy, affecting everything from corporate bonds to mortgage rates and our credit card bills. Because rising interest rates could put a crimp on spending by both households and businesses, many analysts expect a recession to begin.

That’s the crunch scenario, which is what markets now anticipate. Rising layoffs and business failures would then drive down demand, leaving stores with unsold stock. Forced to clear their shelves, they’d then drop their prices, or at least hold off raising them further, putting an end to the rapid inflation of the last couple of years.

That’s the standard model of the business cycle, and rah-rah-free-market economists like Larry Summers can barely hide their glee at the prospect people will soon start losing their jobs.

But the problem is that those who, like him, have been predicting a recession, have been doing it for a while now. Yet job markets still haven’t got the memo. On the contrary, recent employment reports on both sides of the Canada-U.S. border have revealed continued high employment amid real wage gains that remain in positive territory.

On the other hand, we have been getting reports of softening demand and slowing credit creation, which would suggest the economy is in fact sliding toward a recession. The result is an interesting but puzzling situation: weakening economies with strong job markets. Moreover, despite the robust health of the job market, inflation has begun declining, which would suggest someone is feeling the pinch.

The answer lies somewhere in the middle. It could be a crunch of sorts has begun – one that breaks with recent trends in that it appears to be happening at the top of the economy. With interest rates rising and profits tightening, asset prices have begun following bonds downwards. And if interest rates stay high, or go even higher, the falls could turn into an outright crash.

In the United States, any big falls would likely happen in the stock market, as investors sell shares to buy bonds. In Canada, it will likely be in real estate. As it happens, such a “one per cent depression” would be the mirror image of what followed the 2008 crash, when ultra-cheap credit fuelled a boom in stock and property markets all while real wages stagnated.

In the short term, everybody will feel the crunch of rising bond rates. Over time, if job markets remain resilient and real wages keep rising, employed people will gradually be able to loosen their belts once more.

But investors will want to stand guard, because the easy ride that central bankers gave them over the last decade, when anyone with cash to spare could get rich just by putting it in the market, appears now to have come to an end. This is the new economy.

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