The Bond Market Rules the World
With the resignation of UK PM Liz Truss and the installation of new PM Rishi Sunak, many are clamouring to identify a culprit for what forced such an abrupt transition. Enter an unlikely culprit: the bond market.
What is the bond market? Why is it so powerful? What are economists saying about our near financial future based on trends in the bond market? Read on to learn more.
What is a bond?
A bond is a sort of loan given by a consumer to a corporation or government. When someone buys a bond, they're essentially loaning the second party money, which the second party agrees to pay back someday (on a specific date) while also paying interest along the way. Industry and the government usually turn to bonds when they need to raise money, say experts at Vanguard.
It seems like a good deal for the government or company in question, right? It is—unless the money isn't there when customers (who, in this case, are the lenders) want their due.
Financial Instability in the UK and US
Recent financial instability in the UK has destabilized the bond market. 2022 was not a stable year for the global economy, with many nations feeling the pinch directly. In short, UK banks experienced severe shortages of funding and tried to turn to selling bonds to boost revenue and balance the budget.
In essence, banks were hoping that pensioners and other at-risk individuals would be willing to loan them a bailout. This did not go well, and as more people either refused to buy bonds or instead cashed outstanding bonds, the UK liquidity issue worsened. Consider it an issue of "the Emperor has no clothes": how could consumers place trust or money in a failing system? When the bank comes to you for a loan, you know things aren't good.
And because the UK and US markets are linked, Americans also feel the sting. While US Treasurer Powell has been scrambling to plan to address economic volatility, the stock market—usually the US's golden goat—keeps falling, and falling, and falling.
But what does this have to do directly with bonds? What's the link?
The Link Between Bonds and Stocks
Long known to be linked in their successes and failures alike, both bonds and stocks have been falling in 2022.
In the simplest terms, when banks are low on funds, they raise interest rates to generate money. But this rise in interest slows economic growth because it makes borrowing money more expensive for consumers. Worse still, this slowdown affects the stock market because the economy slows down considerably when nobody can afford to borrow. This causes an economic crisis, one of which is brewing as we speak.
So a bond crisis wherein banks try to "fundraise" often results in raised interest rates, leading to a stock crisis because economic growth slows to a halt. Further, rising interest rates make new bonds—purchased at those higher rates—more valuable than older bonds through something called the yield curve. This, in turn, makes it awfully tempting to cash out those old bonds before they lessen in value further—a process that only further undercuts banks' financial stability.
It's like building a pyramid while people remove blocks from the base!
The result is a timid stock market, expensive bonds for the wealthy, increasingly cheapened bonds for long-timers (who can't afford to buy new bonds after cashing out their old), and an economy in crisis.
What Can You Do?
To stay afloat in this volatile economy, it's best to educate yourself on the stock market and its relationship to bonds and economics. Forewarned is forearmed, and consumers will need all the protection they can get as the UK and US economies to struggle to regain their footing.
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Alpesh Patel OBE