In addition to the hawkish Fed, new drivers have emerged, US Treasury yields are feared to rise to this level, fund managers eager to get out of the huge losses in 2022 are disappointed, but new opportunities may also arise...
Concerns about fiscal conditions and concerns about a prolonged rise in interest rates caused U.S. Treasuries to tumble sharply in the third quarter, and some investors believe the U.S. economy will weaken further.
U.S. and German government yields were expected to post their biggest quarterly gain in a year at the end of September, disappointing fund managers, who had hoped bonds would extricate themselves from historic losses in 2022.
While bond yields appear to have peaked earlier this year, central banks have taken a hawkish approach again in recent weeks, sending bond yields soaring again.
In the U.S., for example, the benchmark 10-year Treasury yield is currently hovering near a 16-year high of 4.55 percent, and some investors say yields could rise to 5 percent, the highest level since 2007. According to Bank of America's Global Research Department, U.S. Treasuries are likely to fall for the third year in a row, unprecedented in U.S. history.
The surge in yields is hurting stocks, with U.S. and European stocks set to fall for the first quarter this year. Global currencies faltered as U.S. Treasury yields led the rally, as the dollar revolved.
Greg Peters, co-chief investment officer at PGIM Fixed Income, said "the market has finally accepted expectations that interest rates will remain at higher levels for longer".
Monetary policy expectations have been a key driver for the market. The Fed's hawkish forecast for interest rates last week surprised investors, with forecasts suggesting that borrowing costs will remain near current levels for much of 2024.
Investors have had to adjust quickly, and traders are now betting that the Fed's current policy rate of 5.25%-5.50% will fall to 4.8% by the end of 2024, well above their forecast of 4.3% at the end of August.
Similarly, investors postponed expectations of a rate cut by the ECB as policymakers insisted on keeping rates high for longer. Money market pricing shows that traders expect the ECB's deposit rate to be around 3.5% by the end of 2024, up from around 3.25% expected at the end of August.
New drivers
Kit Juckes, head of global FX strategy at Societe Generale, said hawkish central banks have weakened the appeal of long-term government bonds, continuing to lead to an inverted yield curve. He also said high U.S. financing needs are putting pressure on the bond market.
"It looks like finding enough buyers for all the Treasuries... It takes a painful price discovery process," he says.
Other catalysts that have become more prominent in recent weeks are also affecting prices, investors said.
These include U.S.-centric fiscal concerns, which have rattled some investors with a downgrade of U.S. credit ratings firm Fitch amid soaring budget deficits. At the same time, the Fed is pushing for "quantitative tightening" to reverse its massive bond purchases in 2020 to support the market.
As a result, "yields will rise until investors believe that yields on longer-term bonds are sufficient to cover the risk arising from the coming large-scale bond supply," said Mike Riddell, senior portfolio manager at Allianz Global Investors.
Soaring oil prices are another key risk that could continue to put upward pressure on inflation, weighing on bond yields. Oil prices are now close to $100 a barrel and have risen 28% so far this quarter.
The yield on benchmark 10-year U.S. Treasuries is up nearly 76 basis points so far this quarter, on track for its biggest quarterly gain in a year. The yield on Germany's 10-year bond, the eurozone benchmark, rose 52 basis points to 2.9 percent, its biggest quarterly gain in a year. Italy's 10-year yields have risen 75 basis points this month and continued to sell off sharply on Thursday after the Italian government raised its budget deficit target and lowered its growth forecast.
What level will yields rise?
In addition to hitting bond investors, rising yields have hit the stock market because it has brought competition for investment and raised borrowing costs for businesses and households.
The S&P 500 fell 3.4 percent in the quarter, on track for its biggest drop in a year, though it is up 11.3 percent so far this year. Meanwhile, Europe's Stoxx 600 is up 5.6 percent this year but down 2.9 percent over the past three months.
Investors have been revising their views on how high yields can go. Strategists at Bank of America Global Research said "sticky" inflation could push the yield on U.S. 10-year bonds to 5 percent, and ING also said German 10-year yields could reach 3 percent.
Ed Al-Hussainy, a senior rates analyst at Threadneedle Investment in Colombia, said the rapid rise in yields "exceeded what fundamentals should be, putting us in a highly speculative position right now," and he said yields were "quite possibly" hitting 5 percent.
Still, despite the market turmoil, some investors saw an opportunity.
Rick Rieder, BlackRock's global fixed income chief investment officer, said Thursday at CNBC's Delivering Alpha conference that he likes short- and medium-term bonds and has been buying commercial paper.
Noah Wise, a portfolio manager at Allspring Investments, believes yields will retreat in December, when investors will have a clearer picture of the Fed's monetary policy trajectory. He said:
"When investors see that the Fed is likely to stay on the sidelines, it won't be so scary to enter this market (of bonds)."