Bond Yields Reflecting Growing Risk With U.S. Debt and Structural Issues
For Wall Street and investors alike, it was good riddance to the month of September, where broad selling pressure weighed on both stocks and bonds. It was a time to be long oil and oil-related stocks, floating rate debt and the dollar. Not much else was working.
Hopefully, October and the ushering in of third-quarter earnings season will help to shift sentiment into a more bullish tone. Still, there are some large unresolved issues that could keep the market on the defensive.
At the top of the list is Fed monetary policy and the change in its outlook for the next year. The market had been expecting the Fed to leave interest rates unchanged at their current levels through May-July 2024 and then begin to reduce the federal funds rate by 100 basis points by January 1, 2025. As it stands, the market now believes the Fed narrative is to hold rates where they are for longer and maybe have room for cuts amounting to 50 basis points on the back end of next year.
This sudden shift in thinking unglued the bond market, sending the yield on the benchmark 10-year Treasury bond from 4.37% to 4.70% in the span of a few days and put the kibosh on any notion of a bullish window-dressing quarter-end rally. That, and seeing WTI crude briefly trade up to $94/bbl, raised the specter of a hot read from the Personal Consumption Expenditures (PCE) index released last Friday. It did reflect higher food and energy prices on the headline number of 0.4%, but it also showed core inflation (ex-food and energy) trending still lower for August with a print of only 0.1%.
As of Sunday, Oct. 1, the closely monitored CME Fed Watch Tool showed an 81.7% probability of the Fed keeping the federal funds rate at 5.25-5.50% at the Nov. 1 Federal Open Market Committee (FOMC) meeting and a 64.8% probability of no rate hike for the last FOMC meeting scheduled for Dec. 13. At the same time, Citigroup CEO Jane Fraiser said she expected the Federal Reserve to raise interest rates in November. However, she hopes there is no need for another hike. Her comment is simply out of touch with reality.
The Fed Watch Tool uses the prices of fed funds futures contracts on the CME to project the real-time probability of federal funds rate changes. The Fed Watch Tool implies that the Fed is done with rate hikes. But that doesn’t guarantee lower bond yields are on the horizon.
At the CNBC Delivering Alpha Investor Summit, hedge fund manager Bill Ackman was again talking about his book where he is short Treasuries via options so as to avoid paying interest on being short the physical bonds. “I would not be shocked to see 30-year rates through the 5% barrier, and you could see the 10-year approach 5%.”
At the same conference, hedge fund manager David Tepper said, “It’s not complicated right now. You’re just not in QE (quantitative easing) times anymore. You’re in the QT (quantitative tightening) era. It’s a higher rate environment. Can’t be the same multiples as before. It’s not bad. It’s just different.” Tepper noted he hasn’t sold anything in his portfolio, with five of the Magnificent Seven stocks as top portfolio holdings. Interestingly, his latest trade was buying a six-month certificate of deposit (CD) paying 6.0%.
Oddly enough, the relief from Friday’s tame inflation report lasted all of about an hour when the market opened Friday, only to see selling pressure return as reports of an expanded auto strike and a government shutdown crossed the tape. Congress did finally pass a short-term spending bill on Saturday that expires in 45 days. Both parties remain widely divided on appropriations for Ukraine, border security and how to deal with the national debt, now topping $33 trillion.
Ray Dalio, the founder of hedge fund Bridgewater Associates, stated, “We’re going to have a debt crisis in this country,” in an interview with CNBC’s Sara Eisen that aired last Thursday. The two were speaking at a fireside chat at the Managed Funds Association. “How fast it transpires, I think, is going to be a function of that supply-demand issue, so I’m watching that very closely.”
Mr. Dalio nailed it. It is a supply-demand issue, and the rest of the world is watching. What they are watching is the Fed trying to shrink its $8.7 trillion balance sheet while Congress passes huge spending bills, lifting the debt ceiling on a constant basis. They are watching soaring lawlessness in some of America’s largest cities. They are watching a crisis at the southern border, a failed energy policy and major dysfunction within Congress — where there is a vacuum of leadership. Only 19% of Americans approve of the job Congress is doing, with 82% of Americans supporting term limits on members of Congress. That includes support from 89% of Republicans, 76% of Democrats and 83% of Independents.
The point here is that while the Fed may see the rate of inflation get down toward its 2% target, that doesn’t necessarily mean Treasury yields across the longer end of the curve will come down in tandem with federal funds rate cuts. The Fed could lose control of the long end of the curve if buyers of Treasuries want a higher return to compensate for the rising risk of soaring debt-to-gross-domestic-product excessive spending, government shutdowns and culture wars.
At some point, and some would argue it needs to be much sooner than later, our elected officials on Capitol Hill must deal with getting their fiscal and social house in order, or those record bond auctions being held every week won’t go so well.
