3 Reasons Why Bonds Might Crash

Three silent forces are undermining the reassuring narrative that “bonds are back.” These are factors largely ignored by the market, reinforced by the belief that after a disastrous 2022, anything with a coupon is destined to rebound. But this time the equilibrium is different — and potentially far more fragile than many investors are willing to admit.

What if the risk is no longer limited to equities, but increasingly concentrated in fixed income?

1) Interest rate risk is much more acute than it seems

The first warning signs come directly from the Federal Reserve. Markets continue to price in imminent rate cuts, a normalization of borrowing costs, and the notion that inflation is “tamed.” Yet none of this is conclusively supported by current macro data.

US inflation remains stuck above 3%, a level the Fed still considers inconsistent with a sustained easing cycle. The Trump administration’s economic agenda — including new tariffs and large-scale reshoring — risks embedding structural inflation. These are not transitory dynamics but deeper forces affecting systemic cost structures: supply chains, logistics, labor, and overall import prices.

Meanwhile, the labor-market backdrop is more ambiguous than headline numbers suggest. Unemployment is falling not due to cyclical expansion, but partly because of automation-driven displacement: AI is compressing specific job categories, distorting the traditional reading of the supply–demand balance in the labor market.

This is where an underestimated signal emerges: the widening divergence between the LEI (Leading Economic Index) and the CEI (Coincident Economic Index). Historically, when the LEI declines while the CEI holds steady, recessionary dynamics often follow. And if the Fed finds itself facing high inflation and a slowing economy, the worst scenario for fixed-income investors materializes: stagflation.

Here’s the key point: if interest rates do not fall — or worse, rise again — long-duration bonds could face renewed downward pressure. Markets are already adjusting: the CME FedWatch probabilities are shifting continuously, reflecting growing uncertainty around the policy path.

The expectation that “low rates will return soon” risks proving illusory. And if that illusion breaks, bonds become the first asset class to absorb the blow.

2) US fiscal risk weighs more heavily than macroeconomic data

The second, often underestimated, factor relates to fiscal risk. The US is running a structurally widening fiscal deficit. This is no longer about cyclical fluctuations but a long-term trajectory: rising Treasury issuance, increased financing needs, and a global fixed-income market showing clear signs of demand fatigue.

Recent Treasury auctions highlight the issue: the bid-to-cover ratio — a key measure of investor appetite relative to supply — shows the potential for weakening demand. Soft auction demand forces the Treasury to offer higher yields to clear the market, pushing up what economists call the term premium.

The term premium is the excess yield demanded by investors to hold long-term government bonds in an environment of heightened uncertainty. When it rises, bond prices fall.

Compounding the problem is the repositioning of foreign investors. China and Japan — historically among the largest holders of Treasuries — have been reducing exposure, not primarily for geopolitical reasons but to manage domestic liquidity, stabilize their currencies, and address their own funding constraints. Lower foreign demand means the US must increasingly rely on domestic buyers — often at higher yields — to absorb new issuance.

3) The bond market is much more illiquid than you might think

The third factor is liquidity — and it is chronically underestimated. Fixed-income markets are structurally less liquid than equities. Despite their larger nominal size, trading is more fragmented, market depth is thinner, and transaction flows are more sensitive to shocks.

A first warning sign comes from the upward trend in SOFR, the US benchmark overnight funding rate. When the cost of secured funding rises, it signals perceived risk among institutions — not a benign signal for market stability.

A structural vulnerability also persists: global portfolio duration remains elevated even after the 2022 bond rout, leaving investors highly exposed to rate volatility.

Then there is the risk of large-scale outflows from bond funds. History shows that when yields spike, retail investors often react impulsively, triggering redemption waves. Funds then face forced selling of relatively illiquid positions, exacerbating price declines and creating a negative feedback loop.

In summary: a market with low liquidity, high duration, and nervous flows is an inherently fragile market. And fragile markets don’t require large shocks to break — small ones suffice.

So?

These signals don’t mark the end of fixed income, but they are warning signs far too loud to overlook. This is not a call for panic or blanket pessimism: some segments of the bond market may struggle, while others could offer compelling risk–reward opportunities.

The goal isn’t to avoid bonds, but to interpret them within a new macro regime — one shaped by inflation, deficits, and liquidity constraints that are rewriting fixed-income dynamics. Every downturn could — and I emphasize could — become an opportunity, if these risks ultimately prove overstated. But ignoring them would be the costliest mistake of all.

Original article published on Money.it Italy 2025-11-27 06:53:00. Original title: 3 ragioni per cui le obbligazioni potrebbero crollare