What's Not Behind the Bond Selloff

And what is

Photo by Denise Chan on Unsplash

As harried policy mandarins and nervous investors gather this week in Marrakech for the annual confab of the World Bank and International Monetary Fund, the formal sessions will mourn the victims of the September earthquake and explore the challenges from de-globalization, climate change and  debt restructuring. But everyone will be checking their devices between sessions to track one question: why are U.S. Treasuries collapsing?

Like any doctor taking a patient’s temperature or mechanic checking an engine’s oil, every assessment of the global economy begins with a check on the cost of borrowing money by the world’s richest and most powerful government. And while there are wide differences on what constitutes “normal,” the recent spike in 10-year treasury yields of 50 basis points in two weeks doesn’t qualify.

Rising yields have grave consequences, especially after four decades of falling rates. Higher borrowing costs can tip America, and the world, into recession. They can trigger financial stress, especially where leverage is high and transparency is low. They drive up the value of the dollar, distorting trade flows that are settled in weaker currencies. Indeed, if Friday’s hot U.S. jobs report drives yields back above 5%, we will be revisiting pressures not seen since June 2007—the first rumblings of the Global Financial Crisis.

But it’s one thing to identify a feverish patient or an overheating engine. It’s quite another to determine the underlying causes of the problem. Indeed, it’s usually easier to start by excluding the obvious suspects and then see what’s left. 

Thus, knowing what we know today, rising bond yields are:

·       Not due to rising inflationary pressures, because inflation is easing. The path over the last year from a 9% consumer price index to the current 3.7% may well be much easier than the final effort ahead to reach the Fed’s long-term 2% target, but the worst inflationary pressures are clearly behind us.

·       Not due to expectations of higher Fed Funds rates.  Even with Jerome Powell’s tough talk about one more potential increase, markets believe this rate hike cycle is nearly over.

·       Not because of any less confidence in the Fed’s determination. Neither surveys of consumer expectations or market measures of long-term inflation have moved much at all.

·       Not because rising geopolitical tensions have led other countries to cut their Treasury exposure. China’s direct holdings seem to be in decline, but a careful analysis reveals little change when ownership through other custodians and related accounts is included.

·       Not due to the recent downgrade by Fitch, which cited concerns around rising debt burdens and political polarization that investors have priced in for decades.

·       Not related to current Congressional dysfunction, which has also long been apparent even before Speaker Kevin McCarthy’s dramatic ouster last week.

·       Not even the scale of borrowing yet ahead. Indeed, the country’s debts have been rising steadily since 1980 as a percent of GDP under both parties. The chance of default remains zero on debt issued in the world’s reserve currency.

So what’s left to explain the recent shifts? Most likely it’s a simply question of supply and demand.

·       More bonds for sale—as the Treasury announced its likely borrowing needs through next year that must cover larger deficits, weaker tax revenues and higher debt servicing costs.

·       Fewer buyers “at any price”—as several thoughtful observers have flagged. Not only does the Federal Reserve continue to unwind its balance sheet, but the world’s largest reserve banks are no longer actively accumulating dollar assets. This leaves mainly price-sensitive buyers who monitor current inflation and prefer shorter term debt unless 10-year bonds offer higher yields.

It's little wonder that the term premium that measures additional compensation bondholders ask for market risk has turned positive again. Nor is it any mystery why the “inverted” treasury curve, that haunting signal of imminent recession, should start steepening again. In principle, markets that pay more for longer loans mark a return to normalcy.

Of course, the risks remain that these higher rates will finally bite. Some hedge fund, some emerging market or some regional bank may yet find itself wrong-footed. Mortgage costs and credit burdens may finally ruin Christmas. But the macroeconomic data on corporate earnings, consumer spending and, of course, continuing wage gains all suggest that this holiday season still looks pretty good.

Meanwhile, yields should stabilize soon. If nothing else, Congressional paralysis will trigger a sequestration process that will limit next year’s deficit. Moreover, 10-year yields at current levels will start to look attractive as Fed rate cuts next year come into view.

None of this gets to the heart of America’s long term fiscal ills, which remain a problem to address through long-term reforms of entitlement programs. But it suggests relief may be in sight for what is -- for now, mostly -- a temporary market imbalance.