In the financial world, understanding market movements and its underlying causes can be a challenging task. Recent events in the bond market have raised some questions, leading to unfounded assumptions about the influence of the Fitch credit rating downgrade on US bonds. This article aims to clarify some misconceptions and shed light on the real factors affecting the bond market.
The Misunderstood Impact of Fitch Downgrade on U.S. Bonds
Contrary to popular belief, the recent downturn in bonds is not a result of Fitch’s downgrade of the U.S. long-term credit rating from AAA to AA+. The 10-year Treasury bond yields have indeed pierced the 4% ceiling for the first time since the banking crisis, and the price of the iShares 20+ Year Treasury Bond ETF ($TLT) has slipped below $100, breaking a significant support level. However, market data suggests that these changes are not linked to investors hedging against a U.S. debt default based on this downgrade
The Clarity From Credit Default Swap Contracts
The credibility of the above assumption comes from observing the 5-year credit default swap (CDS) contracts. These contracts reflect market apprehension about the U.S. government defaulting on its debt. If the bond sell-off were related to Fitch’s downgrade, we would expect to see a rise in these contracts. However, they have remained stable since the Fitch announcement. Although they spiked in April and May 2023 due to the debt ceiling crisis, they have since retreated to January 2023 levels.
The Real Causes Behind Bonds Breaking Down
Now that we’ve established that Fitch’s downgrade isn’t the culprit, let’s explore the actual reasons behind the bond breakdown. Two primary factors are contributing to this scenario: the rising economic surprise index and increasing Japanese bond yields.
Rising Economic Surprise Index
Since 2021, a correlation has been observed between the U.S. 10-year Treasury yield and the economic surprise index. Upside surprises in recent economic data have been pushing yields higher. Conversely, if we see economic weakness in the months ahead as we head into a recession, downside surprises in economic data would exert downward pressure on bond yields, causing bond prices to increase.
Rising Japanese Bond Yields
The second significant factor driving U.S. yields up and bond prices down is the Bank of Japan (BOJ). The BOJ recently announced a change in their yield curve control policy, a tool they’ve used to keep bond yields capped near 0%. Following this announcement, Japanese 10-year Government bond yields made several aggressive moves higher.
Japan holds a significant position in the U.S. Treasury market, owning about $1 trillion worth of U.S. Treasury bonds. Since 2012, Japanese bonds have yielded less than 1%, leading Japan to accumulate higher-yielding foreign debt, notably U.S. government debt.
However, as Japanese bond yields rise, it puts upward pressure on U.S. government bond yields. This is because Japanese investors are starting to sell their U.S. bonds to buy Japanese bonds instead. Over the past few months, Japanese and U.S. government bond yields have been highly correlated, meaning that the rising Japanese bond yields have put significant pressure on the U.S. government bond market, causing Treasury yields to spike.
Conclusion
The bond market is a complex entity influenced by a myriad of factors. While it’s easy to draw quick conclusions based on synchronous events like the Fitch downgrade and bond market shifts, it’s essential to delve deeper into market data and broader economic indicators. In this case, the rising economic surprise index and Japanese bond yields are the key drivers behind the recent bond market dynamics. As these conditions continue to evolve, the bond market will likely reflect these changes, reinforcing the importance of understanding the underlying factors that drive market behaviors. Click here to get free trial for 7 days! Subscribe to our YouTube channel and Follow us on Twitter for more updates!
Read more: The Implications of America’s Downgraded Credit Rating and How to Navigate Them
