Here’s the illustration of the problem:
US 10 year yields, daily
US 10-year yields are rising at a rapid pace. US 10-year yields have risen to 4.70% from 4.0% since early August.
The moves have come despite stable market-measured inflation and Fed expectations. Aside from some moderate underlying strength, there haven’t been any big economic surprises either.
The scariest part about it is that there’s no good explanation for why it’s happening.
Lately, there’s been some hope that it was quarter-end or some kind of one-off puke but with two auctions missing this week (including today), it’s increasingly clear that real-money demand just isn’t there. There are scenarios where this blowout isn’t necessarily a bad thing and scenarios where it’s terrifying.
Here are some of the ideas floating around:
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Foreign buyers disappearing
There is always talk about China backing out of the Treasury market. A decade ago it was more of a worry because they held a larger share of the bond market but because of deficits and Fed buying that’s been narrowed. The data shows that China’s holdings aren’t falling, at least not quickly but it also shows that holdings aren’t growing. The signal here is that they’re letting holdings slowly run off. That doesn’t sound scary but if China isn’t buying and the Fed isn’t buying then someone else has to. Increasingly, the countries that aren’t friendly with the US are following China’s lead so it may be that there isn’t as much sovereign demand as believed and that higher rates are needed. Moreover, it’s very tough to tell exactly what sovereign buyers are doing because so much of it is routed through offshore channels so it could be better/worse than believed.
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Higher for longer
The rise in long-dated yields has come with US data proving resilient, especially in the past two months. We just had another blockbuster jobs report and US spending data has been fine. The signal from that may be that the US can tolerate higher rates and if that’s the case, then the Fed won’t need to cut rates any time soon. Moreover, it means we might be in a new regime for short term rates in the 3-6% range rather than the 0-3% post-financial crisis regime. Ultimately, that kind of thing would necessitate some changes in the real economy — particularly the leveraged economy — but it’s looks like the real economy can handle it. What’s clear though is that other countries can’t handle it so while the US may be in a higher-rate regime, the rest of the world isn’t, which is materially USD bullish.
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Volatile inflation future
If you look at inflation pricing in the market it’s low and even today’s CPI report and the moderate reaction around it looks like a market that’s less concerned about inflation. At the same time, the bond market is the smartest money on earth so it could be signalling something that’s not visible elsewhere. Could we be headed to a regime of higher (or at least more-volatile) inflation? History argues that it’s likely as wages reset and that’s exactly what we’re seeing with some tough strikes this year. Moreover, if there are no job losses in the US, workers will get increasingly bold in job switching for higher wages. Is that what the bond market is seeing? Or are bonds worried about commodity-led inflation? Or inflation from de-globalization? There are a handful of possibilities here but ultimately they’re not too scary because the Fed can always hike rates further.
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Debt and deficits
The period from 2009-2022 will ultimately be remembered as the easy-money era. Government deficits simply didn’t matter, culminating in a period of negative sovereign rates. The US embarked (and continues to spend) on the IRA and CHIPS Act, with hundreds of billions still in the pipeline. However one thing could stop and reverse all the spending: the bond market. Yields running higher will add an increasingly-difficult financing element to sovereign deficits. There has always been a limit to sovereign borrowing but the fear is that due to QE and the pandemic, we crossed that limit 2-3 years ago and didn’t realize it, leaving a hole that can only be filled with harsh austerity. The US isn’t ready for that kind of pain economically or politically and where it ultimately leads is deeply unsettling.
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Quantitative Tightening
The Fed and other central banks have amassed huge balance sheets. All that bond buying may have masked the true cost of government borrowing for more than a decade. We may eventually learn that rather than hiking up short-term rates, the Fed should have quickly wound-down its portfolio (or better yet, not let it get so large to begin with). If we find out that monetary financing was truly critical, that’s going to put pressure back on to do more of it, continuing to send unreadable signals into the market. What’s particularly worrisome about this line of thinking is that other central banks have done just as much QE as the Fed and in the case of Japan, much more.
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All of the above
The sum of all bond market fears is that the combination of deficits, QE, ultra-low rates and a general market mania (think NFTs, crypto and meme stocks) built a house of cards in the global economy that’s just starting to crash down. Yes, silly season has been over for awhile but what’s beneath is an economy that looks more like NFTs than a real economy and the price is just starting to be paid. If this is the sound of the bursting of the greatest bubble of all time, then god help us because the economic, market, fiscal and political ramifications are terrifying and there’s nearly nowhere to hide.
What’s the trade?
All of that begs the question of: Where can you hide? Bonds are the traditional safe haven and that’s obviously a no-go zone. Cash works but where? As bad as these problems could be in the US, it’s still the reserve currency of the world (and will be for our lifetimes) so this could all result in a huge overshoot in USD. Perhaps gold does better? There is clearly some reserve accumulation going on and the latest bounce in gold has been strong. Gold is the kind of asset where price gains feed on themselves and I can certainly see that kind of thing happening. At the same time, it’s tough to be confident because gold and sovereign gold can be sold if things go bad. Hard assets may ultimately prove to be winners as well in a broad currency debasement but it’s tough to buy things that benefit from strong end-user demand in a bleak world. That said, those kinds of counter-intuitive trades are often the best ones.
What’s ultimately the fear scale that’s 12/10 is that there is nowhere to hide or at least nowhere to make money.
