The Bond Market’s Balancing Act Is Perfectly Normal

Remember when near-zero interest rates squeezed retirees on fixed incomes and left pensions with huge shortfalls? I suspect they’re happy to see US interest rates returning to normal.

Yes, balance is being restored to bond markets after an unusually long period of unusually low interest rates. Short-term rates, which are mainly an inflation gauge, are only slightly elevated because inflation is running a bit hot. Long-term rates, which build on short-term rates, are also roughly where they ought to be.

The bond markets have an elegant order. Inflation, which is usually expected to hover around 2% to 3% over time, is the anchor. Short-term rates add a percentage point to inflation on average to encourage spenders to save. Long-term yields add another percentage point to motivate investors to lend for longer. The result is an average 10-year Treasury yield of 4% to 5%, slightly less than the current one.

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Bond markets have a knack for finding equilibrium when yields drift, even if it takes some time. Higher rates attract bond buyers, which pushes them down, and lower rates entice investors to seek higher returns elsewhere, lifting them up. The same seesaw applies to prices of things purchased with borrowed money, such as homes, college tuition or stakes in private companies. Lower rates make them more desirable and expensive, while higher rates curb demand and soften prices. With rates returning to more normal levels, signs are already emerging that the housing market is slowing, expensive universities are struggling to fill seats, and private equity firms can’t sell their businesses.