Why Are Bonds Selling Off Again?
It is no secret that 2020 has been an unpredictable and uncertain year across the globe. With the ongoing coronavirus pandemic and multiple lockdowns, instability in the stock market has been the norm. This uncertainty has been reflected in the bond market, one of the oldest and most important financial instruments. In recent weeks, bonds have seen extreme volatility—everyday traders and investors are asking, “Why are bonds selling off again?”
When it comes to uncertainty, investors tend to flee to safety. Ordinarily, bonds are viewed as safe-haven investments, offering a steady stream of income backed by government and corporate credit. However, ever since the Federal Reserve cut its target setting rate to nearly zero in March, bond yields have fallen and volatility in the bond markets has increased. This decrease in yields has presented difficulties to bond investors who are now wondering why bonds are selling off again.
The Fluctuating Interest Rate Environment
When it comes to the financial markets, a significant factor driving bonds selling off is the interest rate environment. Generally, when the interest rate is lower, the bond yield will be lower and the price of bonds will be higher. When interest rates are higher, the opposite occurs. After the Federal Reserve cut its target setting rate to 0.25%, bonds began to sell off.
There has since been a continued demand for bonds (largely fueled by governments as they used to deficits to offset the economic effects of the pandemic), causing the price of bonds to push higher. Consequently, yields on bonds have fallen to their lowest level since the financial crisis in 2008.
Rising Yields and Yield Curve Inversion
This lower interest rate environment is causing problems for existing bond investors who need to pay higher yields to bring in new investors. To move up in yield—and thus return—bond investors are now selling off existing bonds. Another factor driving bonds selling off is a “yield curve inversion”, which occurs when the yield on longer-term bonds dips below the yield on short-term bonds.
A yield curve inversion is often a sign that the economy is headed for a downturn in the near future, as it signals an unwillingness among investors to hold longer-term bonds and an anticipation of future rate cuts by the Federal Reserve. This is why bonds are selling off again—investors are no longer willing to buy bonds, and instead, are selling off their existing bonds in anticipation of a falling rate environment.
The Impact of Monetary Policy
The Federal Reserve has played an active role in the bond markets this year, in an effort to stabilize the markets during the pandemic. Specifically, in March, the Federal Reserve announced quantitative easing (QE) measures, which seek to push the federal funds rate lower and keep longer-term loan rates at low levels.
While this has created a more accommodating environment for borrowers, it is having a negative effect on those holding bonds. To counter the impact of quantitative easing, the Federal Reserve has also launched a massive bond-buying scheme, which has had the effect of pushing prices higher and yields lower. This bond buying program has had the unintended consequence of causing bond investors to sell off their holdings, contributing to the recent sell-off.
The Impact of Tax Cuts and Spending
The stimulus package approved by Congress earlier this year is also driving the selling off of bonds across the market. This includes a direct boost to consumer spending (through direct checks payments and extended unemployment benefits) as well as temporary tax breaks for businesses and individuals.
As the economy bounces back, there is the potential for higher inflation and rising interest rates. This is causing bond investors to sell off existing bonds in order to invest in higher yielding assets. As companies look to grow, tax cuts could cause companies to take on more debt and issue more bonds, which would put further downward pressure on the price and push up yields.
With an uncertain economic future, volatile bond markets are to be expected. The Federal Reserve’s monetary policies and Congress’ fiscal policies have had an unanticipated negative effect on bond investors, causing many to sell off their holdings due to fears of rising inflation and higher interest rates. With ongoing uncertainty, bonds investors should remain vigilant and be prepared for more wild swings in the markets.
