The Bond Market is Boss – Three Things You Need to Know

At a party, you might notice one of two people. There’s the busy host – welcoming guests, serving drinks, introducing everyone, playing DJ… everywhere, and involved with everything. Then there’s the quiet guy in the corner – the one who owns the space pays for the lights, bought the beverages, and waits for others to come to greet him.

In the world of investing, the stock market gets all the attention and is the life of the party. And the bond market is that other guy who actually makes everything happen.

The volume of stocks traded every day is about half that of bonds. And the global stock market is only about one-third the size of the global bond market. As we’ve said in the past, the bond market knows where the economy is headed. And it has a big say in your day-to-day life… in at least three important ways that you might not realise.

1. Interest rates

Bond interest rates, especially those that mature within five or ten years, are directly related to the interest you pay on your mortgage, car or college loan.

When bond prices rise, bond yields (or, the interest rates paid by bonds) go down. That’s one of the keys to understanding how bonds work… when bond prices rise, bond yields fall.

Short-term interest rates are indirectly set by central banks, such as the U.S. Federal Reserve. But longer-term bond rates are set by the bond market. The collective action of all the world’s bond traders determines a bond’s yield.

To get the global economy back on its feet during the 2008-2009 global economic crisis, the Federal Reserve started buying trillions of dollars of government bonds through its quantitative easing programmes. It did this to reduce lending rates.

All of this buying caused the price of bonds to rise (because prices rise when there is a lot of buying) – and, as a result, yields to fall. As yields declined, banks could offer customers cheaper mortgages and car loans. By making it cheaper to borrow money, central banks hoped that more people would borrow – which would help boost the economy.

In a similar way, the bond market affects your savings account’s interest rate. It has to do with the difference between what the bank earns in interest and what they pay the depositor. This is called the yield spread. The bank pays the depositor more interest when bond yields are higher – they earn more interest, so they can afford to pay depositors more interest.

Of course, the opposite is also true – banks provide lower interest rates when yields are low. There are even markets where rates are now negative, which means depositors are paying banks when they deposit their funds. That’s turning finance on its head.

2. More household debt

Many loans now come with a very low-interest rate, due to a global bond market with historically low yields. This has encouraged many people and governments to take on a lot more debt.

Management consulting firm McKinsey & Co. reports that between 2008 and the end of 2014, global debt jumped 40%, or about US$57 trillion. Total global debt, including all household, corporate and government debt, now totals over US$199 trillion. Household debt grew by 21% over the same time period (well behind government debt which grew by 75%).

Household debt levels are usually measured by the household debt-to-GDP ratio. This compares total household debt to the size of a country’s economy. Since 2008, this ratio has risen in every major Asian market except India and Japan, as shown in the chart below.

At a certain point, debt levels become unsustainable. And as debt levels rise, servicing them becomes more difficult – and costly. Perhaps an even greater risk is that some loans and mortgages have a variable, not fixed, interest rates. If rates rise, so do monthly debt payments, which could lead to higher default levels.

3. Cheaper at the pump

The U.S. has increased its oil production in recent years to become the world’s biggest oil producer. Since June 2013 its oil production has gone up 18%, which equals an extra 1.3 million barrels of oil produced per day. This – along with a number of other factors – contributed to the sharp fall in oil prices between June 2014 and February 2016. Despite oil prices recovering over the past 5 months, they’re still 55% below June 2014 highs.

Low-interest rates also played a big role in oil prices’ sharp fall. Thanks to low-interest rates, many oil companies were able to finance new drilling projects that – at higher interest rates – would not have been economical. If bond yields were higher, and companies were paying more interest for borrowing money, many of these projects would not have been started because they wouldn’t be profitable.

But falling oil prices mean that many of these projects are now in the red. Some oil companies have gone bust. Others are waiting and hoping for prices to rise to make things economically viable again. In the meantime, they continue to pump oil just so they can generate enough cash to make their already low debt payments.

Of course, the bond market isn’t the only factor involved in lower oil prices. But the ability of oil companies to borrow at low rates has played an important role.

Most people don’t realise that what happens in the bond market has a major effect on the stock market, world events, and our daily lives. So it pays to pay attention to what the financial world’s “quiet guy in the corner” is doing.