Interest rates are rising. It’s not clear why. But soon something will break

John Rapley is a contributing columnist for The Globe and Mail. He is an author and academic whose books include Why Empires Fall and Twilight of the Money Gods.

Something odd is happening in markets. Interest rates keep rising but it’s not clear why. Meanwhile, whereas surging rates normally hurt share prices, the stock market keeps going up (if at a slower pace than before).

This strange tension may not last, though. If things continue this way, eventually something will break. Bonds already have. Plunging prices on government paper have sent yields – the rate of interest paid on a bond – sharply upward. Although Canada’s 10-year bond has risen half a percentage point since the start of the year, those of many other countries, including the United States, France and Japan, are up by more than twice that.

That, in turn, is starting to place strong internal pressure on vulnerable governments. As the French government tries to placate bond investors with budget cuts, the country erupts in revolt. Britain is just one disappointing budget away from another Liz Truss moment, when her short-lived government’s disastrously received 2022 mini-budget panicked bond investors and sent interest rates soaring. In the U.S., the Treasury Secretary’s boast that he was “the house” against which traders shouldn’t bet has made him look foolish, as investors dump U.S. bonds. The question now is how long this can continue before a full-blown panic breaks out.

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Forecasting the path of interest rates is proving difficult. Several explanations have been floated for the dramatic rise in bond rates but none of them seem to adequately explain what’s happening. Ordinarily, interest rates are meant to reflect expectations of inflation, but long-term expectations haven’t yet risen much among investors.

Some bond analysts suggest that rates mirror nominal GDP growth and that the U.S. 10-year bond was always going to settle around the current American growth rate of 5 per cent, yet U.S. yields blew past that level and have just kept rising. The Financial Times (paywall) recently correlated bond yields and oil prices and concluded that the Iran war triggered the surge in yields, but oil prices have plateaued and yet rates keep rising. A team at the Bank of England found that hawkish statements from Federal Reserve governors drive interest rates up, yet the trend seems inexorable even when Fed officials turn dovish.

Still, for all the gaps in our knowledge of what’s going on, there are some recurring variables that help us to read the tea leaves. To begin with, it’s clear that rising interest rates are in fact starting to hurt the economy. Although the Canadian property market has been spared the worst, the situation in the American one is pretty dire. Equally, outside of AI, investment is flat in much of the U.S. economy and construction of most anything other than data centres is declining.

Meanwhile, coinciding with the rise of interest rates everywhere is an excess of supply over demand in bond markets. Across the Western world and especially in the United States, rising government debt and deficits have now been joined by massive borrowing from the hyperscalers, choking the supply of capital to the rest of the economy. In other words, if the increasingly big bet being placed on AI doesn’t pay off, the eventual fall could leave a more damaged landscape.

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And everywhere, inflation is proving more persistent than expected. Although oil prices have frustrated the efforts of central banks to reduce inflation, a factor that is starting to turn up more often is climate change, with extreme weather raising prices on insurance, food and energy (owing to the need to build more resilient infrastructure). For instance, the FAO food price index is up nearly 6 per cent since last year owing in large part to the impact of extreme weather. These costs may turn up on grocery-store shelves by the end of the year.

Finally, interest rates have become more volatile because of changes in bond ownership. Twenty years ago, pension funds and central banks, which are rate-insensitive and hold bonds for the long term, were the principal buyers of government bonds. Today, they’ve largely retreated from the market: central banks are buying more gold and the Canada Pension Plan, for instance, which once invested almost exclusively in government bonds, today lodges only 12 per cent of its holdings there. The vacuum left by their withdrawal has been filled by hedge funds, which buy and sell aggressively to juice returns. So, when bond prices fall, today’s investors often dump bonds to generate cash, driving interest rates upwards more rapidly.

Because we don’t yet know with certainty why interest rates are racing ahead of central banks, we can’t say if the worst is past or yet to come. But put together what we do know and it seems that unless we get a major AI-induced productivity breakthrough, rates may keep rising until the stock market falls. With signs of strain already emerging in non-AI parts of the U.S. economy, that moment could be approaching. It may time to err on the side of caution and start preparing for a rainy season.