The month of September proved to be challenging for global investors, with increased volatility and declines in prices across most sectors. Notably, the technology sector, a standout performer for most of the year, wasn’t immune as it too fell victim to declines. On the other hand, the U.S. dollar strengthened against most major currencies, as it often does during periods of broad market weakness. The Canadian dollar was the exception as it largely kept pace with the greenback, due predominantly to rising oil prices. Meanwhile, bond yields have risen (while bond prices have fallen) meaningfully as of late. Below, we address what has driven this new bout of angst.

One catalyst for the rise in volatility has been a growing appreciation that interest rates may stay higher for longer than originally expected. Central banks in Canada, the U.S, and England kept their policy rates unchanged at their most recent meetings. Still, their language clearly emphasized a message they have been trying to deliver for some time: the need to tread cautiously with future policy decisions and to avoid cutting rates too early. Most central banks have acknowledged that inflation has come down but are awaiting more definitive proof that inflation is under control. Moreover, an uptick in North American inflation, an increase in U.S. job openings, and some improvement in the U.S. manufacturing sector, all suggest underlying resilience in the economy, which bolsters the case for sustained higher rates.

The swift move higher in government bond yields (and the corresponding price decline) has been particularly noteworthy. For example, the 10-year U.S. government bond yield rose from nearly 4.25% at the start of September to close to 4.75% recently, marking a 16-year high. The move in Canada has been similar, with the 10-year yield rising from roughly 3.55% to 4.15% over the past month. This shift isn’t attributable to a single factor. A combination of economic resilience, anticipation of an extended period of higher rates, lingering inflation concerns, and lower demand from traditionally big investors, such as foreign governments, central banks, and commercial banks may have contributed. Moreover, there has been a growing supply of bonds as governments increase their issuance to fund their budget deficits. In other words, lower demand and rising supply have both played a role.

The rise in government bond yields is having a broader impact on markets than one might assume. Most people appreciate that higher rates raise interest costs for borrowers. However, these rates also influence the prices investors are willing to pay for various investments. That’s because government bonds, widely regarded as being nearly “risk-free”, often set the minimum return investors demand from other asset classes. If held to maturity, investors can count on the government returning their full principal, in addition to making promised interest payments along the way. If you’re an investor and you see that these bonds are now yielding 4% versus 1% a few years ago, it may change how you evaluate the prospect of investing in riskier assets such as stocks or real estate. This reassessment can result in a valuation adjustment, with prices that fall as bond yields rise, and vice versa. Some investments naturally have more sensitivity to this phenomenon than others.

While the recent uptick in volatility and market declines have been orderly so far, we are mindful that bond yields may continue to move higher in the near-term. However, we believe that current yields, which are near decade highs, present some of the more attractive opportunities in fixed income in some time. We also believe that sustained high interest rates will eventually take their toll on the economy, which, in turn, should help re-establish the diversification benefits of fixed income in portfolios as bond yields begin to settle down.