For those of us who traded through the dot com bubble of the early 2000’s, it felt like the apocalypse. A lingering doom that you felt would never end as each trading day saw more financial pain. In the 2-year window of time from March 24th, 2000, to March 24th, 2002, the S&P 500 dropped nearly 51%. This decline was so severe that it is now in textbooks around the world as one of the worst stock market declines since the Great Depression. Today, and we're witnessing another seismic shift, this time in the bond market. Much like the roller coaster rides of equity markets, bond markets aren’t immune to tumultuous turns.
Historically, bonds are viewed as a safe haven. A place where you can park your money and receive a consistent rate of return without subjecting yourself to the chaotic gyrations of the stock market. A common financial planning tool is to tell customers that their age should be the percentage of their portfolio that should be in bonds. For example, someone who is 70 years old should be 70% bonds, 30% equities. It’s a strategy which may expose you to much more risk than you were bargaining for! At present, bond funds like Vanguard Total Bond Market ETF (BND), iShares Core U.S. Aggregate Bond ETF (AGG) and Vanguard Intermediate-Term Corporate Bond ETF (VCIT) have experienced declines of well over 20% the last few years. These all pale in comparison to the monumental 53.34% decline in the iShares 20+ Year Treasury Bond ETF (TLT). Yes, this is worse than the dot com bubble crash. So much for safety!
It's no secret that bonds, traditionally seen as the more stable siblings of equities, have taken a hit. But what's driving this crash? Global economic shifts? Central bank decisions? Inflationary pressures? Likely, it’s a cocktail of all these factors, each contributing its weight to the bond market's current predicament.
Before you go off and start pointing fingers at the current president, or the ones before, let’s look at what happened. When the financial crisis hit in 2007, the Federal Reserve took unprecedented actions to help prop up the markets. It began with “Quantitative Easing” or QE. This is where the Central Bank buys billions of dollars’ worth of longer-term bonds in an attempt to drive yields down. By driving down yields, it pushes money out of bonds and into stocks. It also lowers the cost of capital, meaning that when companies borrow money for growth and expansion, it is at a cheaper rate. These actions are designed to facilitate broader economic growth and create jobs. The assets held by the Fed in August of 2008 were just under $900 billion. 5 months later, they held $2.2 trillion. Keep in mind, this is money that the Fed didn’t have. Essentially, they printed money without printing anything.
These actions worked. After 3 rounds of QE and Operation Twist, unemployment declined, stock markets soared, and business got back on track. However, the Fed kept buying assets to keep the fire going. By January of 2015, their balance sheet had doubled to an eye watering $4.5 trillion. This, not so invisible hand, pushed the equity markets significantly higher, creating the biggest bull market in US history. Then Covid hit. As you can see on the chart above, from Feb 2020 to June 2020, the fed balance sheet jumped from $4.1 trillion to $7.1 trillion and continued to climb to a peak of $8.9 trillion by 2022.
Basic finance tells you that when you increase money supply it will most likely be followed by inflation. Currently, the fed is aggressively raising rates to fix the problem that they put us in in the first place. When you add to that the unfathomable debt that our government owes, the situation gets much worse.
From 2008 to today, total public government debt has increased from $9 trillion to $33.58 trillion. By the time you read this, it will be over $33.6 trillion. The treasury department sells bonds to help pay the interest payments on that debt. That said, they are selling more bonds than ever before. To get buyers to purchase these bonds, they are forced to offer higher yields, which pushes the price of bonds down. The recent downgrade by Fitch Ratings made the situation worse by bringing into question the US’s ability to make the interest payments they owe.
Long story short, yields will most likely continue to surge higher until one of three things happens:
1 – The Fed begins to lower interest rates and the short end of the yield curve drops. For this to happen, inflation must decline significantly. Economists expect this to happen sometime in mid-2024.
2 – Demand increases for longer term bonds. This is unlikely due to the growing debt levels and the inconceivable possibility of a US default.
3 – Congress significantly shrinks the budget and reduces debt. Let’s be serious, this will never happen.
With the current global conflicts and the US Governments propensity to send vast amounts of money to help one side of the conflicts, the debt level will most likely continue to rise. This leads to more bonds sold by the Treasury Department, and ultimately yields will continue to rise. Good news for those looking to lock in a steady rate of return for a set period of time, but a nightmare for those invested in bond funds or selling their bonds before they mature.
Bonds aren’t just pieces of paper or digital entries; they're the backbone of many financial instruments and derivatives. Their influence permeates pension funds, insurance companies, and even the equity markets. A tremor in the bond market sends ripples across the financial spectrum as we witnessed earlier this year in the banking sector. Failures in Silicon Valley Bank, Signature Bank and First Republic Bank were fueled by the sharp rise in interest rates and massive losses on their bond holdings.
Crashes, corrections, and downturns are integral to the financial markets. They test our mettle, our strategies, and our patience. While the current bond market crash might seem daunting, armed with knowledge and a disciplined approach, there's potential to not just weather the storm but to emerge stronger.
The key is to stay informed, stay diversified, and never be guided by panic. Use these moments to reassess, recalibrate, and reposition. After all, in every market's ebb and flow lies a world of opportunities for those willing to seek them out.
On the date of publication, Merlin Rothfeld did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
