Bonds, shaken and stirred – Moneyweb

James Bond’s favourite drink is a vodka martini – shaken, not stirred. For government bonds, a cocktail of factors has once again pushed yields higher.

There is much debate over which reason is more important, but the net result is that bond investors are feeling punch-drunk after a week in which borrowing costs for several major governments reached multi-year highs.

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In the short term, the strain is coming from two distinct areas: inflation and growth. Oil prices above $100 a barrel and a global diesel shortage have reignited inflation fears.

Bonds hate inflation, but inflation expectations embedded in the bond market – the difference between nominal and real yields – have not moved all that much.

Most of the increase in bond yields has come from real yields, which got another leg up from solid economic data as the artificial intelligence (AI) capex boom continues apace.

Notably, September’s S&P Global Purchasing Managers’ indices point to accelerating business activity in the US and eurozone despite higher energy costs. Strong growth is generally good news, but typically not for bonds.

S&P Global Composite Purchasing Managers’ indices

Source: LSEG Datastream

Debt and politics

The longer-term problem lurking in the background is debt and politics.

France stands out as a country that is both heavily indebted and politically fragile ahead of April’s presidential election. Far-left candidate Jean-Luc Mélenchon has openly discussed cancelling some of the French government’s debt.

He is unlikely to win, but a victory for far-right front-runner Marine Le Pen would introduce uncertainty over domestic policy and France’s relationship with the European Union. Her Rassemblement National party is less Eurosceptic than it was in the past, but is hardly pro-EU.

This at a time when Europe’s biggest challenge is smarter integration, especially in finance, technology and defence, to match the scale of the US and China.

France’s gross government debt is already at 118% of GDP, according to the IMF, while its annual deficit of 5% of GDP means things are getting worse.

Yet, like so many other developed countries today, France is deeply divided politically. Without political consensus, addressing big problems is difficult.

Memorably, in 2023 President Emmanuel Macron proposed a modest increase in the retirement age, from 62 to 64, to improve long-term fiscal sustainability. The reforms were withdrawn after millions of people took to the streets in some of the biggest protests in recent French history, some of which turned violent.

Read:

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Countries that borrow in their own currencies rarely experience a debt crisis. France and other eurozone members, however, occupy a grey area, since the euro is a shared currency backed by a shared central bank.

10-year nominal government bond yields

Source: LSEG Datastream

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The US midterm election is also around the corner, but it should have a limited impact on markets.

Democrats are likely to win the House and possibly the Senate, but President Trump is not on the ballot. It means no big change in policy until at least the 2028 election. However, political gridlock also means the country’s rising debt level will not be addressed and will continue festering.

The US government is expected to borrow almost $2 trillion from the bond market this year, and will now do so at higher yields than in recent years.

However, that is just the new borrowing.

There are also around $8 trillion of maturing bonds that must be rolled over – in other words, old bonds swapped for new ones. These maturing securities will generally be rolled over at higher yields.

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US consumers and businesses are now facing a future of more expensive borrowing

For instance, if the Treasury rolls over a five-year security issued in October 2021, it will be replacing a bond that yielded 1% with one yielding 5%. In this case, the level of indebtedness has not increased, but the interest burden has.

Land of the rising yields

And then there is Japan, whose central bank is gradually normalising interest rates after 30 years of near-zero rates. The Bank of Japan cut its policy rate to 0.5% in September 1996 and did not raise it above that level until December last year. At its September 2026 policy meeting, the rate was raised to 1.25%.

There are always two sides to the story.

For borrowers, interest rates are at three-decade highs, while the 10-year government bond yield is now trading at 3% for the first time since August 1996.

Read/listen: Investing in Japan: The good and the bad

For most Japanese investors, however, this means they can earn a decent yield on domestic fixed-income assets for the first time in their careers.

For many years, Japanese capital flowed abroad in search of higher returns, helping make Japan the world’s largest net creditor. Japan is also the largest foreign holder of US Treasuries, for instance.

If more Japanese portfolios tilt towards domestic exposure, there are fewer potential buyers for the trillions of US and European bonds being issued.

One too many

So far, higher yields have not hurt stock markets, with the AI theme still captivating investors.

However, just as there comes a point in the evening when one cocktail too many makes a hangover inevitable, there is also a point at which bond yields become too high for equities.

We just don’t know where that point lies.

There are three broad ways this can happen.

First, bonds could compete with equities at the margin for investors’ capital. Put differently, if a “safe” asset such as a government bond can offer a 5% nominal yield, or a 2.5% inflation-protected yield, riskier equities should arguably offer a higher yield to continue attracting buyers. Higher yields mean lower prices.

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Second, higher borrowing costs could make life difficult for indebted companies. While corporate borrowing has generally been disciplined in recent years, there are always weak links. Hidden problems usually emerge in rate-hiking cycles, as happened with the failure of Silicon Valley Bank in 2023.

Third, to the extent that higher bond yields slow economic activity, they can put pressure on top-line growth. For instance, US mortgage rates hit 7% last week as a direct result of the bond market sell-off, which will put further pressure on the housing market.

As noted, business activity has been remarkably resilient this year. But even amid the fevered build-out of data centres, there are players who are geared and vulnerable, and there will likely be projects that no longer make economic sense at higher borrowing costs.

This last point also highlights why bond yields typically do not keep rising indefinitely. Beyond a certain point, higher borrowing costs lead to weaker economic growth, while interest-rate expectations begin to fall (leading to an inverted yield curve).

A retreat in oil prices would also calm things down.

Removing the punch bowl

It remains a difficult environment for central banks, as inflationary pressures are largely coming from the supply side.

They cannot reopen the Strait of Hormuz or increase refinery capacity, and their main tool – interest rates – is more effective when inflation is demand-led; in other words, when prices are rising because consumers are spending a lot of money.

William McChesney Martin, the longest-serving Fed chair, famously compared this to a “chaperone who has ordered the punch bowl removed just when the party was really warming up”.

Nonetheless, cost increases caused by supply disruptions can spill over into other areas, pushing up the prices of other goods and services. A weaker currency would make this worse, while the longer people experience high inflation, the more likely they are to believe it will persist.

It was against this backdrop that the South African Reserve Bank’s Monetary Policy Committee (MPC) met to decide on interest rates last week. The decision to raise the policy rate to 7.25% was unanimous.

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While Stats SA reported that consumer inflation eased slightly more than expected to 4.4% year on year in August, steep fuel price increases in September and early October are expected to push inflation higher again.

According to the Reserve Bank’s projections, inflation will run slightly above 5% in the final quarter of 2026 and the first quarter of next year, before base effects bring it down to 3.9% in the second quarter of 2027.

Since fuel prices increased sharply in the second quarter of this year, it creates a high base for year-on-year comparisons twelve months later.

The Reserve Bank expects inflation to be close to its 3% target by the end of next year.

SA inflation and interest rates

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Source: LSEG Datastream

While higher fuel prices feed through into higher inflation readings, they also represent a real income shock that will weigh on household finances and business margins.

Deciding where to place the emphasis – on the downward pressure on economic activity or the upward pressure on inflation – is difficult, and most central banks have adopted a cautious approach since the war started.

The Reserve Bank cut its economic growth forecast for this year from 1.4% to 1.2%, but still expects growth to accelerate towards 2% over the medium term.

Its forecast model, the Quarterly Projection Model (QPM), does not point to any further hikes. Indeed, it did not favour an increase at this meeting, given that inflation is expected to return to target eventually.

However, with risks tilted to the upside amid uncertainty over global fuel and food prices, and against a backdrop of rising interest rates globally, the MPC felt compelled to act.

While the Reserve Bank does not follow the US Federal Reserve mechanically, it remains on alert when the Fed enters a rate-hiking cycle.

Sarb economic forecasts at the July and September MPC meetings

Source: South African Reserve Bank

Unlike France, Japan and the US, South Africa’s government is trying to stabilise its debt level.

This might seem surprising, given that doing so is politically difficult and this is a divided country too. But there is sufficient political consensus that failing to act now will only make matters much worse down the line.

Even with a municipal election looming, next month’s Medium-Term Budget is likely to stick to the script of fiscal prudence.

It is easy to get caught up in the negatives – and there are many risks out there – and miss the opportunities.

South African government bond yields are well above any reasonable future inflation scenario, and if the Reserve Bank achieves its 3% target, forward-looking yields on offer from local bonds are still very attractive in real terms.

Cash is yielding around 3% in real terms, based on the Reserve Bank’s inflation forecast for the next 12 months.

And while South African investors have traditionally been reluctant to venture into global bond markets, the opportunities are starting to look more interesting.

A calculation by BlackRock shows that 84% of global fixed-income assets, by market weight, now yield more than 4%, compared with just 20% between 2010 and 2021.

Long-term fiscal problems mean allocations should be scaled appropriately, and further near-term volatility seems likely. Nonetheless, the best indicator of future returns from bonds has always been the starting yield. Yield-seeking South African investors seem to be spoiled for choice.

Izak Odendaal is an investment strategist at Old Mutual Wealth.

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