Are Bond Vigilantes Returning?

Bond vigilantes have appeared again! 

From a “fundamental” standpoint, I’m at the point that Treasuries and bond yields are at the higher end of my range (instead of below, which they were just a couple weeks ago). Fed rate-cut projections have approached our base case (still a tiny bit more aggressive than we expect, but not by my much).

What concerns me is that last autumn, we saw Treasury yields march higher. Relentlessly. Almost every day yields went high. Bad news for bonds, much higher. Good news for bonds, briefly lower, than “poof” there went the gains and we saw higher yields.

While not as pronounced, we saw a similar pattern early this year.

While there were a lot of moving parts, back then, there are a few similarities (ignoring the big difference, which is of course, the Fed has now cut rates).

• Inflation might not be dead. For the past month or so we’ve been harping on the idea that while we are not likely to see a big surge in inflation, the market is exposed to any reasonable uptick, which is our current base case.

• The debt ceiling. Certainly, the swoon last autumn had a lot to do with the debt ceiling debate. At some level, maybe the debt ceiling discussions just reminds everyone that no one in D.C. actually cares about the debt. They just want an excuse to get a few more pet projects approved to raise it, until the next time, when they will re-enact the “drama” of caring, but will just spend more and raise it. 

• Positioning. Many missed the rally. Many (including ourselves) missed how low yields would get (3.8% seemed too low, yet we got to 3.62% on 10’s). Presumably that stopped out most shorts, dragged in reluctant buyers and had momentum buyers build up. Also, from experience dealing in the retail space, many retail investors (and their cheerleaders) seem to equate Fed cuts with lower yields across the curve, which is far from a given, as we’ve seen. That likely brought in buyers who now regret it.

• The election? We’ve argued that once people really start thinking about the economic policies, we will realize that almost whatever government is formed, we will have higher debt. While tariffs have received a lot of attention, let’s not forget that things like student loan “forgiveness” are really just shifting debt that was owed by individuals to debt that is now owed by the taxpayers. Any form of “sweep” is likely to spook bond markets to much higher yields.

• Foreign selling? Given everything that is going on in the world on a geopolitical front, maybe foreigners are selling again? China, launching their own stimulus may be further reducing their holdings? They have gone from $1.1 trillion as recently as 2021, down to $775 billion as of the end of August.

I want to bet against the bond vigilantes (which seems to be betting against myself), but at the very least you need to own some options or something to protect you from a move to much higher yields.

We may be at the high end of our range (I might have to nudge that higher), but I remain convinced (as we’ve discussed recently) that the risk of a 50 basis point move higher is far greater than the chance of getting a move 50 bps lower on 10’s.

I guess I’m saying that I don’t think they will win, but I’m certainly hoping they will, and will bet a bit with my heart on this one!

Earnings

We are once again seeing large moves post earnings, often big enough to move the entire market, which I don’t think is a good statement on the health of the market. However, the overall market has often faded, which I think is a really negative statement on the health of the market.

We get several key market leaders reporting earnings this week. Maybe they will all beat and go higher. Maybe each beat will drive the overall market higher. Somehow, I think the hurdle is high and the overall market feels “squishy” enough (the S&P 500 finished the week down 1%) that I think the market favors the bears — especially if the bond vigilantes keep “winning.”

This Week

Unless something occurs to convince the market that there will be a clean sweep in the election by one party, I think earnings and the bond market will drive stocks (at least after the relief rally that the Middle East is once again likely to calm down).

If bond yields rise and earnings disappoint, then stocks could face some more sustained selling (a down 5% week isn’t out of the question).

But that is a far from certain outcome. More earnings like Tesla TSLA could create positive surprises, and even as someone who was bearish bonds, yields seem a little high.

So stay the course. Definitely add closed-end muni bond funds (my top fixed income allocation, that we try and time buying and selling around a core position).

Be prepared for some weakness, but if it doesn’t materialize, buy small-caps, value and I’m starting to look to commercial real estate. I haven’t committed to it, or decided on a best vehicle, but digging into this is my top priority for the week.

Good luck and keep an eye out on the election, but I don’t think that is driving markets here.

At the time of publication, Tchir had positions in closed-end muni bond funds.