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A seismic shift is underway in financial markets as interest rates rapidly rise, testing investor faith in the long-running narrative of perpetually low rates.

Yields on key benchmark Treasury notes climbed to their highest levels since 2008 this week, sounding alarm bells for stock markets and raising concerns about fragility in the banking system. The yield on the 10-year Treasury note surged as high as 4% while the 30-year Treasury yield topped 3.75%, levels not seen since before the Great Recession.

The spike indicates growing conviction that the Federal Reserve will keep interest rates elevated for an extended period to combat stubborn inflation. This marks a decisive break from the market’s prevailing assumption that ultra-low rates were here to stay. After over a decade of unprecedented easy money policies, expectations for a “new normal” of higher rates are forcing a painful reset across financial markets.

Fed Determined to Stay the Course on Rate Hikes Despite Growing Economic Risks

At the root of the bond market tremors is steadily building evidence that the Fed stands ready to tolerate economic weakness to rein in inflation running near 40-year highs.

Comments from multiple Fed officials this week underscored the central bank’s steely commitment to tighter monetary policy even as recession risks rise. On Monday, Fed Vice Chair Lael Brainard affirmed that rates will need to rise further and then remain “higher for longer” to curb demand and reduce price pressures.

Her remarks followed similarly hawkish signals last week from Cleveland Fed President Loretta Mester, Fed Governor Michelle Bowman and Atlanta Fed President Raphael Bostic.

This tough anti-inflation stance from the Fed sank in further Tuesday after JOLTS data showed job openings rebounded sharply in August. The report challenged expectations that the overheated labor market may be starting to cool on its own, raising the likelihood of more aggressive Fed action.

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“So much of the economy has evolved because of low rates and negative rates,” said Quincy Krosby, chief global strategist at LPL Financial. “Now it’s adjusting to what would be considered a historically more normal rate regime.”

After more than 15 years of hyper-stimulative monetary policy, the shift to higher rates for a sustained period feels destabilizing for markets conditioned to perpetual cheap money.

Stocks Plunge as Surging Yields Add to Recession Fears

The grim outlook for rates and growth fueled a broad equity market selloff Tuesday. The Dow Jones Industrial Average plunged over 800 points, shedding 2.4%. The S&P 500 fell 2.7% while the tech-heavy Nasdaq Composite slid 3.4%.

Behind the equities rout is growing concern that the Fed’s war on inflation will tip the economy into recession. Morgan Stanley and Goldman Sachs both warned this week that a downturn is likely as the full force of Fed tightening hits.

Rising rates threaten to squeeze consumers, drive up loan defaults and cool the red-hot housing market. This changing rate environment also pressures corporate profits and elevates credit risks. Around 36% of banks tightened lending standards last quarter as recession signals flashed — a potential harbinger of broader pullback in credit that could further slow growth.

Treasury Market Drama Exposes Cracks in Financial System

At the epicenter of the market shakeout are Treasuries, as rapidly rising yields lay bare fragilities lurking beneath the surface.

Banks are especially vulnerable, facing potential balance sheet stress from unrealized bond losses that are piling up ominously. Banks lost $558 billion on securities holdings last quarter, with losses on Treasuries alone totaling $310 billion, per FDIC data.

These paper losses raise concerns about weakening bank capital buffers and risks of selling into an adverse market environment. For some troubled banks, being forced to raise dilutive equity capital could become necessary if losses grow too large.

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Ominous bond market moves have previously presaged issues at overleveraged firms. Hedge funds holding the wrong side of interest rate derivatives saw major blowups in 1994, 1998 and 2022 amid huge spikes in yields.

Financial institutions have become highly dependent on easy money policies of the past 15 years. Now the swift return to more normal yield levels threatens to expose other hidden instabilities in the system after such a prolonged period of distortion.

Foreign Bondholders Continue Exodus from US Debt

Another worrying trend exacerbating bond market volatility is shrinking foreign appetite for Treasuries as yields march higher. Major overseas creditors like China and Japan have pared holdings substantially in recent quarters.

China slashed its stash of US government debt by over $175 billion in the past year. Japan also cut its Treasury reserves in 2022. This waning demand from major buyers comes as US borrowing needs continue rising, pushing the federal debt above $31 trillion.

At the same time, the Federal Reserve is rolling assets off its nearly $9 trillion balance sheet in the most aggressive quantitative tightening campaign ever undertaken. The Fed’s balance sheet runoff further reduces a key source of demand for Treasuries.

This deteriorating backdrop for US fiscal finances adds another layer of uncertainty for bond investors. The possibility of supply/demand imbalances pressuring prices higher may make some foreign creditors even more inclined to head for the exits.

Peak Pain Close as Yields Climb Too Fast?

Some bond market veterans see signs that the surge in yields may be approaching an apex. Technical factors and positioning have likely exacerbated upward moves in rates rather than just fundamentals.

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“The selling is not explained by fundamental factors,” said Joseph LaVorgna, chief economist at SMBC Nikko Securities. “Given the fact that we’re multiple standard deviations away from where rates should be suggests to me that we’re closer to that point.”

The blistering pace of the yield spike raises risks of market accidents that could force the Fed’s hand again. Previous episodes of outsized rate swings have created crises requiring Fed intervention to restore order.

“They can’t hike another basis point. It’s just too much pain,” said Larry McDonald of The Bear Traps Report. “This type of action is bringing out the pain, and the Fed is now more aware of the bodies that are buried.”

Cracking in the real economy or financial system from higher rates could stay the Fed’s hand. If a recession takes hold, markets are betting the central bank would need to resume asset purchases to stabilize conditions.

For now though, the Fed seems intent on pushing forward with its aggressive monetary tightening campaign to decisively break entrenched inflation expectations. This hawkish stance continues fueling intense volatility across bond and stock markets.

Effective communication of the Fed’s reaction function is pivotal to avoid additional market disruption during this extraordinary period of policy normalization. As the era of zero rates fades into the past, guiding investors to embrace a brave new world of higher rates without derailing the economy poses a major challenge for the central bank.

The path ahead looks rocky as markets undergo the painful process of recalibrating to this new regime. But learning to live with rates well above zero may ultimately prove healthy in re-imposing some semblance of normality after years of distortion from extreme accommodation.

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