Are Stocks Going to Crash Because of Rising Bond Yields?

For the past few weeks, the financial markets have been quite unsettling to observe, with growing discussions regarding a potential impending crash.

The primary concern at present revolves around the rising long-term yields of US Government bonds. The bigger question is: What is causing this rise in yields? This analysis is crucial in determining whether we are witnessing a necessary market adjustment or the onset of a crash.

There are a handful of factors:

The Federal Reserve has signaled the possibility of raising interest rates once more before the year's end, and that higher rates will persist for a longer period. The market had to adapt to this altered expectation, resulting in an increase in longer-term bond yields, and the correction in the market commenced in September.

I hold the view that this is a transient effect, as the market has already factored in this new outlook. Unless the Federal Reserve adopts a hawkish stance once more in November, this factor is expected to have a diminished impact going forward.

Beginning in early 2022, the Federal Reserve has initiated a process of reducing its balance sheet. This entails the possible sale of government bonds, which in turn increases the bond supply, ultimately causing yields to rise and bond prices to fall. Given that the previous four rounds of Quantitative Easing (QE) have expanded the Federal Reserve's assets to over $8 trillion, this reduction process is expected to be protracted. But I believe the asset unwinding will be gradual to ensure that the markets can absorb it.

In June 2023, the suspension of the U.S. debt ceiling granted the government the ability to expand its borrowing and expenditures. One of the primary means of raising funds involves issuing additional Treasury debt. By August 2023, the total Treasury issuance had reached $14 trillion, representing a significant year-on-year surge of 24.9%. This influx of Treasury debt into the market has led to further declines in prices and subsequent increases in yields.

However, when we examine the breakdown of this issuance, it becomes evident that the issuance of longer-term notes and bonds remained relatively consistent with previous months. It was the issuance of short-term Treasury bonds that saw a significant increase. Interestingly, the yields on 6-month and 1-year bonds did not experience substantial increases. It appears that interest rates have likely reached their peak.

The U.S. government has been unable to address its deficit problem. Politicians are resorting to the threat of a government shutdown to compel fiscal responsibility. Notably, Speaker of the House Kevin McCarthy was removed from his position for the first time in history due to him acceding to a short-term spending deal passed to avert a government shutdown. Currently, the U.S. lacks a Speaker, yet the problem of excessive spending remains.

Concerns have arisen about the possibility of the U.S. being trapped in a cycle of debt. While there is potential for a U.S. sovereign debt crisis in the future, I do not believe it is imminent.

This is because there is currently no other nation capable of stepping in to replace the United States. Most investments will continue to be concentrated in U.S. stocks and bonds due to the absence of viable alternatives. Emerging economies like the BRICS nations are not yet prepared to assume this role. Therefore, the U.S. will likely maintain its ability to issue debt, with investors still eager to purchase it, especially when yields are appealing.

The U.S. 10-year bond has recently encountered an extraordinary three years of consecutive losses, marking a historical anomaly spanning the past century. Despite their reputation as secure investments, these bonds have demonstrated the potential for significant losses.

Consequently, investors are unnerved, leading to a cascading effect of selling. It's also possible that certain bond investors are awaiting for long-term yields to stabilize before buying.

Considering all these factors, I believe it's less likely that we're headed for a crash; it appears to be more of a correction. Every now and then there are bad news relating to the financial markets. As the saying goes, the stock market climbs a wall of worry and the rising long term yields is just one of the many.