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Trouble in the Bond Market

Published October 3, 2023

Bonds are getting beat up again. The 10-year Treasury yield today rose to its highest level since 2007. It is joined by the 30-year, which also crossed the 2007 rubicon. The short end of the curve is hardly looking any better, with the 2-year also selling off — though at the time of this writing still a couple of bps below its level from 16 years ago.

Two things appear to be driving this:

  1. Fears of ‘higher for longer’ interest rates. Inflation remains too big of an issue for the Fed to ignore and Jay Powell & Co. are forced to continue their hawkish path when it comes to monetary policy.
  2. Fiscal concerns, specifically that escalating US budget deficits will create more supply of bonds than can be absorbed by investors.

The first issue is not new at all. It has very much been the driving force in markets for about two years. So much for our assessment that Fed fears had peaked. Maybe it will turn out to be early. Or perhaps just dead wrong. The point is, these concerns have not gone anywhere. If anything, they’ve intensified.

The fiscal concerns are a new wrinkle, clearly not helped by the developments in Washington. There is a lot of very dramatic language over this in the financial media. On some level the question does need to be asked as to who will buy all these bonds.

The Fed

This brings us back to the Fed, as the central bank is the largest single holder of US treasuries. And therein lies the problem because the Fed is reducing its purchases of treasuries through quantitative tightening.

With the largest holder/purchaser of bonds effectively leaving the game (at least for now), it creates a big hole from the demand side of the equation. Mutual funds are the second-largest holder of treasuries. Maybe they will step in and buy, though surely many funds are already sitting on substantial losses in their bond portfolios. Can they keep buying the dip? Maybe?

Other major holders — depository institutions (ie banks), state and local governments, pensions, and sovereign nations like Japan, the UK, and China — are not exactly equipped to pick up the slack when it comes to bond buying. Banks are constrained by new restrictions brought by the bank failures this spring and don’t exactly have the balance sheet prowess to expand their treasury holdings. State and local governments can at best expected to maintain the pace of their treasury purchases. Japan and China have their own fiscal problems to deal with (and bail out, when it comes to China). The UK is facing a recession and can be counted out for its own fiscal issues.

That’s all worrisome and could indeed create more pressure on bond prices in the short term.

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Fed Fears Show Signs of PeakJerome Powell quote from Sept. 20, 2023 press conference: "We want to see convincing evidence really that we have reached the appropriate level"

Fed Fears Show Signs of Peak

Published September 21, 2023

The following is an amended version of the Sept. 21 Daily Contrarian. This briefing and accompanying podcast are released to premium subscribers each market day morning by 0700. 

The Federal Reserve yesterday kept its key interest rate unchanged as expected but made enough noise about “higher for longer” to scare investors. Stocks and bonds sold off.

chart of 2-year yield on Sept. 21, 2023

In the case of 2-year bonds, yields spiked to a level not seen since 2006 (see chart on left).

So clearly the market was not prepared for this hawkish language from the Fed. Meanwhile, all Powell really did is just reiterate what the inflation data is telling us, which is that there is more work to do before monetary policy can be loosened. Yes, the dot-plots did move a bit, but that just tells us how FOMC members feel right now. New data can and will change their views.

The Opportunity

Whether they’re justified or not, there is a sense now that maybe Fed fears have reached a bit of a fevered pitch. Just look at the headline in today’s Wall Street Journal: “Higher Interest Rates Not Just for Longer, but Maybe Forever.”

WSJ headline: Higher Interest Rates Not Just for Longer, but Maybe Forever

Ignoring for a minute that “forever” is a pretty long time, this take conveniently forgets that we’re talking about the same Powell Fed that flooded the system with liquidity during Covid and then kept rates too low for too long. The Fed may have to keep raising rates now (thanks to its own doing), but there is no way in hell this continues “forever.”

This is the kind of language you look for to indicate a turning point. And if fears of Fed are indeed at a peak, then fear of fixed income — specifically short-term bonds — could be at a peak as well. And that could be a buying opportunity for bonds. At some point the economy will slow, inflation will ease, and the Fed will cut rates. Then investors will pour money into bonds as they abandon the riskiness of the equity market. We aren’t there yet. But we’re a day closer.

The only way the Fed doesn’t eventually pivot is if we get stagflation. And even then: That will just force the Fed to choose between protecting purchasing power (price stability) and sending the global economy flying off a cliff or flooding the market with liquidity again to spur economic growth. If you’ve been paying attention to the Fed these last 30 years it will be pretty obvious what path it chooses — especially if it’s faced with this conundrum during an election year.

Here’s short audio where the host gets into this a little bit:

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Debt Ceiling Talks Bring Opportunity to Buy Stocks

Published May 24, 2023

The following is aggregated discussion a topic that has been presented to premium subscribers over the course of the past week, including in today’s briefing. Details on membership is available on our Supercast or Substack.

Debt ceiling talks are slowly coming home to roost. They were apparently the cause for yesterday’s selling, which saw the S&P 500 and Nasdaq drop by 1% each. There hasn’t really been any noticeable progress since House Speaker Kevin McCarthy said he had “productive” discussions with the White House.

That was on Monday. No news is bad news here, which makes sense when you’re up against an approaching deadline. This has caused the inevitable doom and gloom headlines and of course plenty of finger-pointing from political partisans.

Reality Check

There is still a week to go before June 1 and even then the US probably won’t be in technical default right away. Secretary Yellen for her part is already quietly backing off the hard June 1 headline. So we can expect to hear more from this for a little while yet. Lawmakers have a vested interest in drawing these talks out to a dramatic conclusion because that attracts media attention and media attention is catnip to these folks.

More than that, actually. It’s their lifeblood. That makes sense in a democratic society. Whoever commands the media can command the voters. Look at the historical record of election outcomes if you don’t believe us. Chances are, the winner won the PR game, whether that individual’s name is Trump or Clinton or Kennedy or Hitler.

The Opportunity

Where stocks are concerned, there hasn’t been all that much in the way of fear-based selling yet. As the reality of a possible default dawns on the market — with each passing day of little or no progress on the debt ceiling talks — one can expect this to change. These could provide an opportunity to buy stocks if one believes this is all political brinkmanship.

That doesn’t mean there aren’t risks. The fears that emerged at the outset, that one or both sides could drive us off a cliff if they decided they could convince their voters it was the other side’s fault, has not changed.

Could the two political parties really be this idiotic? It’s probably not a good idea to discount their idiocy in any way. But if ignore the clickbait and you look at how little actually separates the two sides right now — and it’s basically just a question how much spending to cut, not whether to cut it — then one has to consider the possibility that this is all just theater, and we, the voting public, the audience.

That makes fear-based dips an opportunity to buy the stocks or risk assets of one’s choice.

Not investment advice (duh). There may be other opportunities — and other pitfalls — not covered here. Do your own research, make your own decisions.

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