Something is breaking in financial markets — Here’s what’s behind the sell-off

That slit sound in financial markets isn’t the typical kind of break, where one asset class or another fractures and gives way. Preferably, this is more a break in a narrative, one that has widespread repercussions.

The narrative in question is the one where the Federal Reserve favours interest rates low and everyone on Wall Street gets to enjoy the fruits.

That’s changing.

In its place comes a chronicle in which rates are going to stay higher for longer, an idea Fed officials have tried to get the market to accept and which investors are simply now beginning to absorb.

The pain of recognition was acute for Wall Street on Tuesday, with major averages down angrily across the board and Treasury yields surging to their highest levels in some 16 years.

“When you keep an economy predicated on zero rates, this fast move [by the 10-year Treasury yield] towards 5%, the calculus has to substitute, because the ramifications are going to change,” said Quincy Krosby, chief global strategist at LPL Financial. “The cost of superior is going up, companies are going to have to refinance at a higher rate.”

The surge in rates is especially ominous as corporate America premiers to third-quarter earnings reporting season, which is right around the corner.

“All of this has to be assimilated and digested by the market,” Krosby combined. “You can see that it’s troubling and it’s difficult.”

There were signs early Tuesday that it could be another inured day for a market just coming off a brutal September.

But the carnage really got going following the 10 a.m. ET release of a Labor Activity be contingent report showing that job openings took a sudden swing higher in August, countering the prevailing wisdom that the enlisting picture was loosening and thus putting less upward pressure on wages.

In turn, traders grew worried that the main bank would be forced to keep monetary policy tight. That sentiment was buttressed this week, when at young four policymakers either endorsed hikes or indicated that higher rates would be staying in place for an granted period.

Along with the slide in stocks, the yield on 10- and 30-year government debt instruments hit highs last seen as the curtness was moving toward the financial crisis.

“So much of the frugality has evolved because of low rates and negative rates,” Krosby said. “Now it’s adjusting to what would be considered a historically more common rate regime.”

Getting used to a more typical rate structure doesn’t sound like such a frightening thing. After all, prior to the financial crisis, the 10-year Treasury yield had averaged around 7%, though that also was skewed by the consequential rate increases in the early 1980s.

But after 15 years of living in an unnaturally low rate regime, normal sturdies, well, abnormal.

Multiple parts of the economy face substantial interest rate risk, but not one more so than banks. The sector was jolted earlier this year by the high-profile failure of a few banks that had erected up too much long-duration government debt, then had to sell at a loss following deposit runs.

In the second quarter, unrealized disappointments on bank balance sheets totaled $558.4 billion, an 8.3% jump from the prior period, according to the Federal Dregs Insurance Corp. Of that total, held-to-maturity Treasurys, which caused much of the turmoil this year, totaled $309.6 billion.

That include is expected to climb, said Wall Street veteran Larry McDonald, founder of The Bear Traps Report.

“The hornets nest is, when your core capital is weak, any weakness on the other side is exponentially worse,” he said. “But if Treasurys go up to 6, 7 [percent on relents], then the leverage goes up exponentially, right? That’s your core capital. That’s the money when you go to the casino you press to put up at the table.”

Should banks have to cover their losses, they may be forced to issue equity, McDonald translated. That, in turn, would be dilutive to share price, a situation that likely factored into a loss Tuesday of diverse than 2% in bank stocks as measured by the .

There are other ramifications as well.

Consumers, for one, are feeling the squeeze of ear-splitting rates on everything from mortgages to credit cards to personal loans. More than 36% of banks clock in tightening lending standards in the third quarter, a level that in the past has been consistent with recessions.

At the having said that time, Washington dysfunction has bond buyers worried about the U.S. fiscal house, with public debt at exactly 120% of gross domestic product and net financing costs running, according to the Congressional Budget Office, toward $745 billion in 2024 after totaling $663 billion this year.

What’s sundry, foreign buyers have been stepping away from U.S. government bonds, with China’s holdings down with respect to 17%, or $175 billion, over the past year, Potential peak for rates