October 5, 2023 - 10:00am

It’s hard to resist the temptation of seasonal metaphors when talking of market crashes — the hot summer giving way to deep freezes — and the “October effect” is very much a thing among analysts. But regardless of whether it’s just a coincidence that many of history’s big sell-offs have happened in the autumn, we’ve now entered crash-watch season as the rout in bond markets deepens.

Although this problem had been brewing for years, the speed of the collapse in bond prices, and resulting rise in yields, has come as a bit of a surprise. I wrote back in August that action in bond markets would continue driving up interest rates, but reckoned then this didn’t make a crash in stocks or real estate a certainty. Now, I’m less sure. With the interest rates on US treasury bonds currently rising at a monthly pace of half a percent, we could be heading for turbulence.

Bond markets don’t function like supermarkets, where the grocer sets the price and you either take it or leave it. They operate more like village markets, where you haggle over everything. If, say, a one-year $100 bond offers $105 on maturity — a 5% return — a buyer seeking 6% can simply offer to purchase it for $99. If no other buyer beats that offer, the government has to take the lower price.

That’s what’s happening in markets just now. There’s more supply than demand, with governments issuing tons of bonds to cover the deficits they’ve built up. But it’s not the run-up in debt that’s new. It’s that central banks are no longer underwriting them. Over the last decade, to keep interest rates low, they subsidised bonds both by issuing cheap short-term credit, which institutional investors then used to buy higher-yielding bonds, and also by buying bonds outright. This added demand, known as quantitative easing, drove up the price of bonds and kept credit cheap.

Now, as they fight to bring down the inflation their easy-money policies caused, central banks have stepped back from the market. Not only have they raised short-term rates, but those which engaged in quantitative easing have switched to quantitative tightening. The US Federal Reserve, for instance, is sucking about $65 billion out of the bond markets each month by withdrawing the demand it once offered.

The resulting rise in interest rates has then created a vicious cycle in which governments that need to re-finance bonds as they mature are forced to issue yet more bonds to cover their increased payments. Goldman Sachs this week estimated that the US government’s interest bill will double in the next couple of years as a share of GDP.

With government interest rates feeding through into the rates private borrowers pay for credit, some real belt-tightening may be on the way. Moreover, investors may sell shares or real estate to buy bonds that are offering higher yields, which could cause a sharp sell-off in other asset markets.

If the bond market rout triggered a crash in other markets, central banks would want to prevent it spiralling out of control. But until they are confident that they have decisively won the war on inflation, they will not provide the sort of massive rescues they did after the 2008 crash, or at the start of the pandemic. Instead, they’ll probably use the sort of piecemeal interventions the Bank of England employed at the time of Liz Truss’s budget fiasco last year when it prevented the bond market from collapsing — but didn’t interrupt the long-term rise in interest rates.

So investors should brace themselves. This autumn could get bumpy.

John Rapley is an author and academic who divides his time between London, Johannesburg and Ottawa. His books include Why Empires Fall: Rome, America and the Future of the West (with Peter Heather, Penguin, 2023) and Twilight of the Money Gods: Economics as a religion (Simon & Schuster, 2017).