Not long ago, the world lived in a time when money flowed freely and was inexpensive. Interest rates in the U.S. were close to zero, while central banks in Europe and Asia applied negative rates to stimulate economic growth. This era is over, and everything, from housing to the business world, is disrupted, especially after 30-year U.S. Treasury yields exceeded 5% for the first time since 2007 last week.

Given the abrupt end to the era of low-interest rates, it’s hard to imagine that this drastic change in yields won’t increase the risk of a financial system accident. For nearly a decade and a half, authorities did everything they could to control yields.

The importance of U.S. Treasuries helps explain why changes in the bond market matter in the real world. As a risk-free benchmark, all other investments are compared to them. As Treasury yields rise, it ripples through broader markets, affecting everything from car loans to overdrafts to government borrowing and the cost of financing a corporate takeover. And there is much debt: according to the Institute of International Finance, a record $307,000 billion was outstanding in the first half of 2023.

Several reasons explain this radical shift in the bond market, but three stand out.
First, economies, especially the United States, have been stronger than expected. This, combined with the substantial amount of cash in circulation in the economy, fuels inflation, forcing central banks to raise their rates.
As fears of a recession fade, the idea that policymakers will have to reverse the trend quickly is losing appeal. Consequently, rates will have to remain higher for longer, possibly even increasing further.
Second, governments issued much more debt at low rates during the pandemic to protect their economies. They now have to refinance it at much higher prices, raising concerns about unsustainable budget deficits. Political dysfunction and credit rating downgrades have added headwinds.
Finally, there is a significant level of geopolitical risk weighing on commodity and energy prices. Put it all together, and the cost of money is rising.
And this higher level suggests significant changes in the financial system and the economies it feeds into. Some money market funds and bank deposits offer a 5% interest rate. The 10-year German rate is at its highest since 2011, while even Japan’s rate is at a level not seen in a decade.

For many consumers, mortgages are the first concrete concern. The dramatic variations in interest rates are truly felt. The U.K. has been an excellent example this year. Many who took advantage of pandemic stimulus measures to secure a cheap offer now face a shocking increase in their monthly payments. As a result, transactions are plummeting, and real estate prices are under pressure. Lenders are also seeing an increase in defaults. In a Bank of England survey, defaults increased in the second quarter to their highest level since the global financial crisis.
The mortgage cost crisis is a story playing out everywhere. In the United States, the 30-year fixed rate has exceeded 7.5%, compared to about 3% in 2021. This doubling of rates means that for a $500,000 mortgage, monthly payments are about $1,400 higher.

Higher rates mean countries have to spend more to borrow, in some cases, a lot more. In the 11 months leading up to August, the interest bill on U.S. government debt amounted to $808 billion, an increase of about $130 billion from the previous year. This bill will continue to rise as rates stay high. In turn, the government may need to borrow even more or choose to spend less elsewhere.
Others also deal with inflated deficits, partly due to pandemic-related stimulus measures. The U.K. is looking to limit its spending, and some German policymakers want to reinstate a borrowing limit known as the debt brake. Ultimately, as governments strive to be more fiscally responsible, or at least give that impression, the burden falls on households. They will likely face higher taxes while experiencing financial difficulties in public services.

U.S. Treasuries are considered one of the safest investments on the planet, and over the past decade, their return on investment was modest due to falling yields. As they approach the 5% mark, these bonds appear much more attractive than riskier assets like stocks. Riskier assets, especially emerging markets, are on the front lines. In the coming months, some countries with weak finances risk bankruptcy.

One closely watched measure is the equity risk premium. In the U.S., it’s the difference between the earnings yield of the S&P 500 Index and the 10-year Treasury yield. This indicator is a great way to assess the attractiveness of stocks compared to other assets. This figure is close to zero, the lowest in over two decades, implying that equity investors are not being rewarded for taking additional risks. It’s a number that investors have largely ignored so far but should serve as a warning given current stock market valuations.

Companies have spent the last decade raising cash at very low rates, basing their business models on the assumption that they would have access to markets if they needed more money. Everything has changed, but most companies had increased their liquidity levels when rates were near zero, so they didn’t need to tap the markets at the beginning of the rate hike cycle. Over time, the problem is now becoming more acute. Weaker companies that relied on their liquidity reserves to weather this period of higher financing costs may be forced to tap the markets. A wave of debt is coming due. And if they turn to the market, they may have to pay nearly double the current cost of their debt. Such pressures could lead companies to scale back their investment plans or seek cost savings, potentially resulting in job losses. Such actions, if widespread, would have implications for consumer spending, housing, and economic growth.

The rise in rates has hurt banks’ willingness to support significant merger and acquisition investments over the past 18 months. This has led to a substantial drop in leveraged buyouts, a vital element of the mergers and acquisitions market. The value of global transactions stood at $1.9 trillion by the end of September, on track for its worst year in a decade. Private equity firms have been particularly affected, with the value of their acquisitions falling by 45% this year to around $384 billion, marking the second consecutive year of double-digit declines.

Commercial real estate heavily relies on borrowing, and the cost of debt is a poison for the sector. Rising bond yields have caused property valuations to drop as buyers demand more attractive returns than risk-free rates. As a result, borrowers must inject more equity if they have it or borrow more at higher rates. The other option is to sell properties in a declining market, putting downward pressure on prices and causing more financial problems. Additionally, the sector faces structural changes, such as remote work and environmental regulations.

While a broader crisis could emerge from anywhere, it’s worth noting that real estate crises have often been the seeds of more significant banking crises.
An overly optimistic market does not currently price in all these factors. The wake-up call could prove to be painful.