Will Bond Yields Spike and Crush The Markets?

Posted February 28, 2021

A rout in the bond market last week sent government bond yields sharply higher and the price of a broad range of speculative assets painfully lower.  For instance, Tesla lost nearly 12%.  Even the price of Gold fell as low as $1,715 an ounce on Friday.

If bond yields continue shooting up this week, the stock market and many other asset classes could very well suffer severe losses. 

So, what is the probability that yields will continue to rise?

To answer that question, this week Macro Watch discusses the two most important factors that cause government bond yields to move:

1. The supply and demand for government bonds, and
2. Market expectations about the outlook for inflation.

The video begins by looking at how many bonds the government will have to sell over the next seven months to finance the massive budget deficit expected for this fiscal year ending September 30th.  It then asks how such a large deficit will be financed and who the buyers will be.  

Here the importance of the Treasury General Account, the US Treasury Department’s bank account at the Fed, is explained.  As of February 24th, the Treasury had $1.44 trillion on deposit there.  That means the government has already borrowed enough to fund a large part of this year’s budget deficit.

However, there is more to the story than that.  If the Treasury runs down the funds in that account by spending that money, it will flood the financial markets with liquidity.  Given that the Fed intends to inject AT LEAST another $840 billion into the financial markets over the next seven months, as well, the problem may become excessive – rather than inadequate – demand for government bonds.  In that case, in terms of supply and demand, government bond yields would be more likely to fall than to rise during the months ahead.

But what about market expectations concerning the outlook for inflation?  This is the more immediate problem.  If investors fear inflation is going to rise, they may be reluctant to buy government bonds.  This, in fact, was the problem that caused the rout last week.  If investors become spooked about inflation, a buyers’ strike could continue pushing yields higher and set off widespread panic across the markets.

Expect to see the Fed respond to this threat early this week.  If government bond yields seem inclined to continue moving up, the Fed is likely to take action over the coming days to ensure that they don’t.  The Fed could announce a large increase in the size of its asset purchase program or even suggest that it may soon adopt Yield Curve Control.  Either of those moves would send yields tumbling.  

There is one other possible scenario, however.  What if the Fed would like to see a healthy correction in asset prices to put an end to the wild speculation that has characterized the markets for much of this year?  What then?  And how likely is that?

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