Expert Sends Dire Warning: Bond Market Crash Could Trigger ‘End of the World’

  • According to Michael A. Gayed, publisher of the Lead-Lag Report, Treasuries are the big story this year.
  • Bonds and Treasuries have experienced unprecedented volatility the past few months, with yields even climbing despite this year’s bear market.
  • For Gayed, Treasury volatility has the potential to plunge the entire financial system into chaos.
bond market crash - Expert Sends Dire Warning: Bond Market Crash Could Trigger ‘End of the World’

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For as much as the S&P 500’s decline this year has tended to dominate headlines, it may come as a surprise that a bond market crash is the more devastating — and realistic — possibility. According to Michael A. Gayed, Chartered Financial Analyst, mutual fund manager, publisher of the Lead-Lag Report and staple of financial Twitter, the story of this year’s economy is rooted in bonds — and it still hasn’t reached its final chapter.

While the S&P licks its wounds after shedding more than 15% of its weight through the course of the year, long-duration Treasuries are still down more than 24%, an undeniably strange phenomenon. Bonds and stocks typically move in opposite directions. As equity markets tumble, it’s only natural for investors to seek safe haven in the quiet, steady, consistent world of corporate or government bonds. This phenomenon typically pushes bond prices up and yields down when stocks sink. Typically. For most of the year, long-term bonds have suffered steeper losses than most stock indices.

According to Gayed, this is a historically unprecedented sign:

“If you were to look at the top 20 biggest declines, the biggest drawdowns for the S&P going back to 1961 … In 10 out of those top 20 largest drawdowns for stocks, Treasuries … made money, meaning they were the counter asset. You could’ve actually made money being in Treasuries during those stock market declines. In nine out of those top 20 drawdowns, Treasuries lost you money, but they lost you a lot less going back to 1961. This year is the only year in history where Treasuries are down more than equities in a steep equity drawdown.”

Bonds are the steady backbone of both domestic and international financial systems. What’s been eating away at the fixed-income sector and what does it mean for the markets going forward?

Fed Rate Hikes Have Put Undue Pressure on Treasuries

Treasury yields are the benchmark by which the entire financial world is based, including everything from mortgage rates to the cost of government debt. As such, a breakdown in Treasuries has long-reaching consequences across the entire U.S. economy. Treasuries, basically by definition, should be more stable than the variable-return equity markets. U.S. bonds are fundamentally pieces of U.S. debt, the safest lender in the world, and offer a fixed return on principle after a set amount of years. The fact that prices and yields are fluctuating so drastically this year is a bad omen for the state of U.S. financial markets.

The question remains: Why are bonds so unstable?

The obvious answer is, predictably, the Federal Reserve. Via increasingly hefty rate hikes throughout the year, the central bank has pushed the federal funds rate from near-zero at the start of the year to its current 4% level. Bond yields are essentially interest on government loans. As such, short-term Treasuries especially tend to be extremely sensitive to changes in lending environments, of which a 4% increase in the benchmark rate would more than qualify.

According to Gayed, rate hikes offer a partial but imperfect answer to this year’s would-be bond market crash.

“… Most people are going to say [the Treasury drawdown] is because of the Fed. I have an issue with that narrative, because the drawdown for Treasuries started August 2020, way before the Fed started hiking rates … Now, part of it, I don’t disagree, is because of the Fed hiking rates fast, and everybody else. Part of it is inflationary, but I think the harsh reality is … you can argue it was overvalued.”

Gayed’s case is relatively straightforward: Treasury prices were already bloated heading into the year. Rate hikes only accelerated their inevitable drop.

“You can argue that that’s where the bubble was, but I think part of this is also just these things happen in data sets. You will always have anomalies and dislocations, where you can’t exactly put together all the causation, because you may not necessarily have full causation around any, one or two variables. There could be a degree of randomness. I know that’s not a very popular answer, but I think that’s the most intellectually honest one,” Gayed said.

Treasury Liquidity Poses a Threat to Entire Financial System

The issue this year is that as rates rose, driving up bond yields and pushing down bond prices in the process, investors have largely abandoned the market. As a result, Treasury market liquidity, the ease of which bonds can be converted to cash or treated as a cash-equivalent, has deteriorated drastically. In October, Bank of America analysts rang the alarm that Treasury liquidity has fallen to its worst point since the Covid crash in early 2020.

The typical metric of Treasury liquidity is the liquidity premiums of newly issued Treasuries compared to their older counterparts. As per BCA Research, the gap between premiums of new Treasuries to old, “off-the-run” Treasuries, is at its widest level since 2015.

Again, volatility is at the center of the conflict. How can bonds be considered a safe and steady retreat when the benchmark rate on which their price and yields are based is under scrutiny?

To Gayed, this bond volatility presents the most immediate threat to our greater financial system, even compared to the slumping equity market.

“If Treasuries now get back to their historical flight-to-safety status, that’s actually a good thing for normalization in terms of the way these various internal relationships are behaving … If you keep having an environment where Treasuries are losing at the same pace and in the same way as stocks, that’s the end of the world.”

Treasuries offer a standard by which other forms of debt are evaluated. This means everything from mortgage rates, stocks, bank loans and more are susceptible to widespread collapse, strictly off the back of a bond market crash.

“I’m not trying to be overly dramatic with that, but all your leverage is based on some collateral. That collateral is the safe collateral. The safe collateral is government debt. You can’t have a functioning financial system if the collateral which your leverage is based off of is more volatile than what you’re leveraging, which is the risky asset. That’s been the dynamic the bulk of the year,” Gayed said.

The Fed’s Inflation Fight Is Inching U.S. Towards Bond Market Crash

A relatively unappreciated aspect of this year’s bond market is the Fed’s suspended bond purchases. For most of the pandemic the central bank was buying up tens of billions in bonds every month as part of its quantitative easing (QE) process. It was yet another way to encourage spending during a time of gross uncertainty alongside near-0% lending rates.

Unfortunately, this year the Fed essentially quit its bond-buying cold turkey. Indeed, since the central bank turned its attention towards inflation, its open-market purchases have not only ceased; the central bank is letting billions in bonds mature off its balance sheet, a product of quantitative tightening (QT).

For much of the post-pandemic year, the Fed was buying up Treasuries en masse to inject money into the stagnant quarantine economy. This not only injected money into capital markets, but also lifted bond prices. Now, the central bank hasn’t just ceased its bond-buying mechanic, but flipped the script completely, letting its roughly $9 trillion in U.S. Treasuries and mortgage securities mature without replacement. With that in mind, it could be argued this year’s bond collapse is in no small part due to the removal of the Fed’s propping force.

Why a Bond Market Crash is ‘End of the World’ Nightmare Fuel

As mentioned, Treasuries and Treasury yields form the basis of asset pricing across the entire economy. The stability of Treasuries is a reflection of their importance as collateral in short-term repurchase agreements and security loans. The simple fact is that for a variety of reasons, a functioning financial system cannot sustain itself when the value of government debt swings wildly from month to month.

For example, if developed countries like the U.S., the U.K. and Japan are suffering speculation surrounding the value of government debt, emerging markets could experience something much, much worse in the case of a collapse. Treasury yields would skyrocket in developing countries across the world, pushing many economies into substantial debt or default in efforts to secure funding. In such a situation, the only option left would be to tax corporations into the ground to prevent entire countries from essentially going bankrupt.

Similarly, things like mortgage rates closely follow certain Treasury yields. Instability in the fixed-income sector would, sooner or later, trickle over into lending mechanisms across the economy. In that regard, a bond market crash is a worst-case scenario for financial systems.

“You can’t have $300 trillion of global debt, possibly refinanced if the speed at which yields are rising was to have persisted the way that we saw … If that speed were to have continued, probably by now you would’ve had the 30-year mortgage rate to 20%. What people were not understanding about the bond market selloff was not that yields were rising, but that the speed at which it was rising could have resulted in cataclysmic ending of everything against all this debt,” Gayed warned.

Now, there are plenty of asterisks around these possibilities. For one, Treasuries have notably stabilized since October. Even according to Gayed, a return to traditional “risk-on” is likely what’s happening right now. Since the 10-year yield peaked at about 4.2% at the end of October, it has eased back down and seemingly steadied. That’s good.

The point here isn’t that an economic collapse is imminent, nor that bonds are a light breeze away from purgatory. The takeaway is that should a wider economic collapse take place in the U.S. or otherwise, it will be off the back of bonds and Treasuries, not equities. If you’ve spent any time reading Gayed’s Twitter, you’ve likely seen the phrase, “save bonds, save the world,” more than once.

Bonds and Treasuries are truly the backbone of the economy. So the next time you’re perusing the typical stock market indices, take a look at Treasuries, even if it’s just a glance. They matter more than you might think.

On the date of publication, Shrey Dua did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the Publishing Guidelines.

With degrees in economics and journalism, Shrey Dua leverages his ample experience in media and reporting to contribute well-informed articles covering everything from financial regulation and the electric vehicle industry to the housing market and monetary policy. Shrey’s articles have featured in the likes of Morning Brew, Real Clear Markets, the Downline Podcast, and more.

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