Bond markets are being hit hard — and it's likely to impact you

There is a sharp sell-off in the bond market, and it has big implications on both the economy and people's pocketbooks.

Yields on U.S. government bonds, especially the 10-year Treasury note, determine the interest rates that people pay on a lot of their debt, including mortgages and credit cards.

And a key bond yield hasn't been this high since 2007.

Several factors are driving the sell-off, including stronger-than-expected economic data and the government's worsening finances.

Here is what you need to know about it.

How bad is the sell-off?

In 2022, the bond market suffered its worst year on record, as the Federal Reserve started raising interest rates aggressively to fight high inflation.

This year, the picture hasn't improved much.

"It's been a very difficult period in time for folks invested in Treasurys," says Katie Nixon, the chief investment officer for wealth management at Northern Trust. "It's been bad."

After fluctuating at the beginning of the year, bond prices have been hit especially hard in recent weeks, sending their yields sharply higher.

Bond prices and yields have an inverse relationship, meaning prices fall when yields rise, and vice versa.

The yield on the 10-year Treasury note — widely considered to be one of the least-risky investments in the world — briefly broke above 5% on Monday. It hadn't been that high since June 2007, when George W. Bush was in the White House and Ben Bernanke was running the Federal Reserve.

It's a jarring trend given that, for years, the U.S. economy benefited from ultralow interest rates.

What's driving the most recent bond sell-off?

A big reason is that economic data has been stronger than forecast.

Although a stronger economy is good news generally, the Fed right now needs a cooler economy to bring down inflation.

That means the Fed may need to continue keeping rates high for a while longer, given that inflation still remains above the Fed's inflation target of 2%.

Wall Street is also worried about the U.S. government's growing debt levels, a big reason why Fitch Ratings decided to downgrade the country's bond rating by one notch from the previous top-rated AAA to AA+.

The U.S. budget deficit surged in the latest fiscal year, in part over increased spending and slowing tax revenues.

There are also more technical reasons.

A big one is that there is less demand for bonds from an institution that has been one of their biggest buyers for years: the Fed.

During the COVID-19 pandemic, the central bank bought trillions of dollars' worth of fixed-income securities. But since 2021, it has been reducing the size of that portfolio as a way to help reduce inflation by removing some of the money from the financial system.

"Making conditions even more challenging is the absence of the Fed as a buyer of first, last or any resort," according to Nixon.

Why do bond markets matter?

Bond yields are critical to the economy because they influence interest rates that people pay on credit cards, car loans and home mortgages.

Higher yields also reverberate across companies, by raising the cost of debt for businesses.

The higher borrowing costs could take a toll on the economy as people, as well as companies, reduce their spending in the face of high interest rates.

Take the housing sector, for instance. It is a critical part of the economy, and mortgage rates are some of the most sensitive to interest rates.

Right now, the average rate on a 30-year, fixed-rate mortgage is 7.63%, according to Freddie Mac. That's the highest it has been since 2000 — and it's fueling a drop in existing-home sales since people who bought property when mortgage rates were lower are reluctant to give up their lower rates.

Interest rates on credit cards are also rising, and so are the interest rates on car loans. According to the Federal Reserve Bank of New York's latest "Quarterly Report on Household Debt and Credit," credit card balances stand at $1.03 trillion — a record high.

In addition, many banks are heavily invested in government bonds, which could make them susceptible to rising yields.

This year, Silicon Valley Bank and two other regional lenders collapsed in part because of concerns about the health of their bond investments. That set off bank runs.

It's not just banks, though. People with retirement portfolios also have a lot of their nest eggs tied up in bonds, making what has happening critical.

What's the outlook for bond markets?

A lot will depend on inflation and the Fed's approach to interest rates.

Wall Street is betting the central bank could be done raising interest rates this year, given that inflation has continued to come down and policymakers have lifted them so aggressively already.

Now, investors and economists are trying to figure out how long the Fed is going to keep interest rates elevated.

Not too long ago, bond investors were expecting that the Fed could start cutting interest rates as early as this year to avoid tipping the economy into a recession.

But now that the economy has proved sturdier than expected, many of them are getting used to the idea that rates could be "higher for longer."

John Canavan, the lead analyst at Oxford Economics, says investors are now "much more pessimistic on rates, as we adjust for Fed policy, adjust for the stronger economy and adjust for the risk that inflation is more difficult to pull down than expected."

That said, things could change. Bonds tend to do well in periods of elevated uncertainty, and right now there are a lot of worries about the world, as Russia's invasion of Ukraine continues and Israel is in a war with Hamas.

Should geopolitics worsen, bonds could see a boost.

But as of now, most investors don't expect the bond market to improve anytime soon.