What are bonds? How do they impact financial markets?

Global stock markets saw sharp retreats in August amid re-rampant bond yields and China’s economic uncertainties. The US long-dated Treasury yields on the 5-year and 10-year climbed to their highest levels since 2007 following Fitch’s US credit cuts. The leading provider of credit ratings downgraded the US long-term credit rating to AA+ from AAA. Investors tend to shift funds from the capital market to the money market. The movements in the US government bond yields primarily contributed to the broader market’s volatility. So, what exactly are government bonds, and how do these correlations work in asset classes?

What are government bonds?

Government bonds are debt securities issued by a government to raise funds for various purposes. Investors who purchase these bonds are essentially lending money to the government in exchange for periodic interest payments and the return of the principal amount at maturity. Government bonds are considered relatively safe investments as they are backed by the creditworthiness of the government issuing them. They are also used by governments to finance public projects and manage their fiscal policies.

The inverse relations between bond yields and bond prices

Bond yields and bond prices are two important concepts in the world of finance. Bond yields refer to the interest rate earned on bond investment, while bond prices represent the market value of a bond. These two factors are closely related, as bond prices and yields have an inverse relationship: when bond prices go up, yields go down, and vice versa.

What are Fitch’s government bond ratings?

Fitch Ratings is a leading provider of credit ratings, commentary, and research that serve as an integral part of the global financial markets. In the context of government bonds, these ratings essentially assess the respective country's creditworthiness. A high rating, such as 'AAA,' suggests a low likelihood of the country defaulting on its debt obligations, implying that its government bonds are a safe investment. Conversely, a low rating like 'BB' or 'C' indicates a higher risk of default, suggesting that investing in these bonds might be riskier.

Correlations between government bonds, equities, and currencies

The complex relationship between government bonds, equities, and respective currencies can be seen as a fine balance dependent on market sentiment and investor confidence. In the most recent trend in the US markets, government bonds have a positive correlation with equities but a negative correlation with the respective currencies. And this movement between asset classes all tied up with the Fed’s rate policy.

Bonds were sold off broadly during the Fed’s aggressive rate hikes in 2022 as the rapidly rising interest rates caused bond prices to fall sharply. Bondholders tend to sell their bonds with lower yields and buy back those with higher yields at much lower prices. At the same time, bond yields, which are determined by the forces of supply and demand for bonds, can be very sensitive to changes in market sentiment. When bond yields rise, it means that investors expect lower returns on their investments, and this tends to increase the risk of owning stocks, since stocks usually offer higher returns than bonds. As a result, rising bond yields can cause stock prices to drop. On the other hand, when bond yields fall, it means that investors expect higher returns on their investments, and this tends to make stocks more attractive from an investment standpoint, which may lead to rising stock prices.

Government bond yields can also be seen as a projection of the central banks’ policy rates. When bond yields increase, the local currency also strengthens against foreign currencies due to investors expecting higher returns from investing in that country’s bonds. This relationship is closely monitored by traders as it has a major impact on global exchange rates and movements in the Forex market. Hence, government bonds usually have a negative correlation with the local currencies due to inversing movements with their yields.

The evidence can be seen in the recent trends of falling US stock markets, jumping Treasuries yields, and strengthening USD. However, investors need to consider all the other macro and micro aspects when making their investment decisions. 

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