Bond yields are at 16-year highs.

The yield on 10-year U.S. Treasury bonds has just hit 4.35%, its highest level since November 2007.

What’s going on?

Aren’t interest rates supposed to stay more or less constant until, as many investors expect, the Federal Reserve and other central banks start gradually cutting them?

Read on to learn what’s happening and what you should expect as an investor.

Yields Aren’t the Same as Benchmark Rates

The Federal Reserve and other central banks set benchmark interest rates.

Bonds, on the other hand, trade freely, and their prices and yields change in response to supply and demand dynamics.

So even though the Federal Reserve looks increasingly likely to pause its interest rate hiking process, the market prices these bonds according to its own outlook.

What does the market think?

It thinks that the U.S. economy is in great shape and that it can handle higher interest rates.

Before, fears of a recession made a lot of investors sell stocks and buy bonds. When investors buy bonds, their prices go up, and their yields go down. (Bonds’ prices and yields are inversely related.)

Now that the market is more optimistic, it isn’t as willing to buy bonds. Some investors are selling. This pushes yields higher.

The market also re-priced bonds (and their yields went up as a result) because the “fear” stage that drove their prices up made bonds expensive. Now their prices have started correcting from higher-than-justified levels.

At the current levels, their prices reflect a more positive economic outlook.

So there’s nothing overly dramatic about this selloff. The market has adjusted its expectations to an improving economic picture.

Unemployment is low in the United States, and inflation is falling.

And the United States isn’t alone.

In Germany, producer prices have fallen more than expected in July, according to the latest data.

While analysts expected that producer prices would fall 5.1%, they decreased by 6% compared to July 2022.

It was the first decline since November 2020 and the most significant decline since October 2009.

Lower producer prices are a key indicator of consumer-price inflation. In July, inflation in Germany fell to 6.5% annualized. It is likely to continue declining.

So, What’s Next?

Some financial media says that this is a panic-driven bond selloff and a sign of trouble ahead.

It’s most likely not the case.

The U.S. government Treasuries remain the world’s key reserve asset.

Governments and private investors will continue buying and holding them because there are few, if any, alternatives.

The fact that Fitch, a credit rating agency, recently downgraded U.S. debt did not change much.

Investors know that the U.S. government remains one of the most, if not the most, trustworthy counterparty.

As the Financial Times points out, investors don’t tend to check the credit rating of the U.S. debt before buying Treasuries.

Investors just buy them when they need to increase their fixed-income allocation.

The future of the Treasury market will depend on one thing: the U.S. economy.

So far, it has proved to be resilient to higher interest rates. And there are no indications that a recession is imminent.

There’s no need to follow the noise in the financial media. The world’s largest economy is in good shape, and we expect positive news in the months ahead.

Thank you for your loyal readership,

The Financial Star team