Moneycontrol Pro Panorama | Why bonds no longer protect against war risk

Funding a war means borrowing from the bond market for any government as defence expenditure shoots up.

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When it comes to courage, a bond investor has more mojo than one who deals with stocks. Not trying to start a war here, but bond investors have exhibited the ability to intimidate everybody: from private investors to policymakers irrespective of geographical boundaries. This requires a special kind of heft which the bond market possesses.

That's because bonds also provide protection from uncertainties and what is more uncertain than a war? After all, the job of a fixed income financial product is to price in every possible risk and provide a steady income to the holder. The US treasury market has been the ultimate hedge against global uncertainties for not just investors across the world, but also central banks and governments. Until now.

The US 10-year bond yield edged up about 5 basis points after Israel launched attacks on Iran’s nuclear sites, in contrast to how a hedge product behaves. To be sure, yields have cooled a bit, but are still elevated. The reaction of the treasury market may seem out of sorts, but it has been so for some time now. Recall some weeks ago that bond yields had surged along with equity losses because of US President Donald Trump’s tariff announcements. Since then, the bond market is trying to rein in Trump’s policies on tariffs and the big, beautiful bill, passed by the Senate eventually, that threatens to balloon spending.

It is safe to say that the US bond market was preoccupied in disciplining policymakers for it to think of offering a hedge against war uncertainties to investors. There is also one other factor: monetary policy. The Israel-Iran hostilities have driven up oil prices and Trump’s tariffs are anyway a quagmire of inflationary outcomes for the US Federal Reserve. With the Fed’s committee hobnobbing on rates currently, the bond market is trying to guess which way Jay Powell will tilt. Will stagflationary fears make him hold rates for longer or will it make Powell cut rates to help growth? Robert Armstrong, in June 17 Unhedged newsletter for FT, points out that it all depends on the sequencing of data, but the Fed will probably do nothing this time.

Beyond American shores too, bond yields have climbed rather than offer a hedge against global uncertainties. It seems that the bond market in almost every  developed nation is either pricing in interest rate increase/pause or trying to punish the sovereign on fiscal profligacy. In the US’s case, both are true. Japanese bond yields are near their highest level in decades because Bank of Japan has been selling off its bond holdings to reduce its balance sheet, roughly the size of the economy now.

The fact that some advanced nation central banks are stuffed to their gills with sovereign paper and most advanced nations including the US government are up to their necks in debt is an upsetting factor for bonds. Supply is unreally high, and investors are wearing thin.

What makes a profligate sovereign even more reckless? A war. Funding a war means borrowing from the bond market for any government as defence expenditure shoots up. That is the case for Russia and Ukraine and now Israel and Iran. But the nature of the conflict and the parties involved along with those that may jump in is such that defence expenditure is elevated almost everywhere. Note that the US is the biggest spender on defence, but ironically its interest payments on the bonds it used for borrowing is now more than its defence bill.

No wonder, the bond market wants to bring the Trump administration to its comeuppance on borrowing like there is no tomorrow. The bond market wants Trump’s trade war to cease and the onslaught of supply to ease. This is one war the bond market is trying to end.

But what about war between nations where the US can also be dragged into? The Israel-Iran conflict is causing enough headache to countries, especially those like India who are net importers of oil. So far, the Indian bond market has been an island of calm and yields have remained fairly steady. In fact, after the Reserve Bank of India’s latest move to cut policy rate and reserve ratio, yields have slipped. The oil price outlook threatens this, but as Pankaj Pathak in his piece here explains, even oil on the boil may not rattle the bonds here. “Rising prices of crude oil might dampen investor sentiment and push bond yields higher. However, given India’s reduced vulnerability to oil prices and strong macro buffers, any adverse impact on the bond market should be limited and short lived,” Pathak writes.

Unlike in the past, where the reaction of bond markets to uncertainties such as war or tariffs was straightforward, it is more nuanced now because the linkages between governments and markets are more complex. Of course, the ability of the bond market ends with stifling economic wars. In wars with guns and tanks, it is much like every other market, a casualty.

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