Thinking About the Unthinkable
As the bond selloff continues, the debt supercycle seems unstoppable, fiscal discipline out of sight and rising inflation a possibility, it’s time to have a tough conversation.
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Bond traders on Tuesday continued to sell U.S. Treasury debt securities. By day’s end, U.S. Two-Year paper paid as much as 4.39%, up five basis points from the close of business on Monday. At zero dark-thirty on Wednesday morning, I see that yield above 4.4%. On Tuesday, the benchmark U.S. Ten-Year Note went out yielding 4.79% (up 4 bps). As I toil away through the wee hours, I see U.S. Ten-Year paper paying more than 4.81%. The long bond (U.S. 30-Year)? Yielded 5.27% (up 2 bps) last night. Yields more than 5.28% early this morning.
Globally, look where you want. British, Japanese, German, Italian debt … all are sporting higher yields on a daily basis than they had the day before. All are sporting yields that are trading at multi-year highs. All reserve currency central banks are probably going to have to increase interest rate targets once the Fed gets rolling. Otherwise, currency valuations will become skewed and that will impact trade more so than any tariffs used as negotiatory tools might.
Interestingly, the yield on the U.S. 30-Year Bond or long bond, reached levels on Tuesday, seen prior to Treasury Sec. Scott Bessent’s Aug. 19 announcement of an expanded buyback program targeting federal borrowing costs. U.S. Ten-Year paper now pays (4.81%) well more than it did (4.71%) on Aug. 18. On Tuesday, Bessent appeared at Newsmax. He said, “I don’t think that I can change the equilibrium (neutral?) interest rate. But what I can do is I can slow things down. I am making sure that there is not a bad, big adverse outcome, and that everything that is done is fact-based.”
Bessent has boasted about the Treasury Department’s “big toolkit.” Using the liquidity management program to double federal buybacks at the long end of the Treasury yield curve probably was not all he had up his sleeve. My guess is soon we’ll know more. Letting this bond selloff approach the mid-term elections unchecked won’t be good for anyone, let alone the party currently in power.
From The G-20
Scott Bessent made the rounds on Tuesday. He spoke publicly from the G-20 press conference at Asheville, North Carolina. Bessent was asked whether increasing borrowing costs for mortgages and consumer credit could become a political liability for Republicans as the elections near. He said, “The most important thing is that we have higher growth.”
Do we?
This Friday’s report on demand for labor for August will tell us a lot about the economy. Another awful month would become a trend. A negative trend would be undeniable.
Bessent went on: “The economy is strong, and importantly, we are creating private-sector jobs here. Interest rates will come down when we get on the other side of this. The economy will accelerate.”
Bessent blamed AI. He pointed to the surge in capital investment focused on the development and expansion of artificial intelligence as a factor putting upward pressure on yields. He’s not wrong about this. I mentioned that this was a factor in this very column earlier this week.
Borrowing to spend on AI has drawn demand for debt securities away from sovereigns and toward tech firms with potentially large cash flows and large “circular” funding deals. This, in Bessent’s terms, creates a near-term “conundrum” for bond markets. Add to this condition a war that does not appear to be ending and run away federal spending at a time that the national debt has run off of the playing field and it does appear that fiscal and monetary policy makers are going to have to come up with new ideas if the “debt supercycle” is to once again, be extended.
Thinking Out Loud…
Federal or sovereign debt is notably different from corporate, or household debt. Sovereign governments (This leaves out individual countries in the Euro-Zone) have powers that businesses and families do not. Governments can raise taxes, can actually persuade (force) financial institutions to buy government debt securities, and can use central banks to absorb imbalances. Governments can engineer or try to manage inflation in order to decrease the value of finite debt loads. Governments can manipulate currency valuations. They do indeed have a big toolbox.
There are limits though, at least potentially. There comes a point where investors will walk away. The public, including foreign accounts, will eventually choose not to purchase a sovereign’s debt securities at yields that said sovereign can afford. At that point, debt servicing costs crowd out other federal spending priorities. We have seen this globally in the past. We are seeing the start of this in the U.S. now.
Remember the bond vigilantes? They still exist. They may be different this time as they may be more algorithmic than human, but they still exist. They are well aware of domestic and global fiscal trends. Yields have indeed moved higher and that move has accelerated of late. In my opinion, this activity currently reflects expectations for a tighter trajectory for monetary policy. This is not yet an increase primarily related to a fiscally focused risk premium. There is, however, a rising risk premium related to fiscal policy.
In the past, crisis after crisis has been postponed (not avoided) by central bank bond purchases using newly created currency. This is known as quantitative easing. QE will be tried again at some point. The expansion of money supply as a tool will be tried again at some point. I do take some solace in that I believe Fed Chair Kevin Warsh is a much more serious economist than were Ben Bernanke, Janet Yellen and Jerome Powell (a lawyer by trade). That said, his resolve will be tried should economic conditions deteriorate further.
An Avoidable Future
Eventually, should inflation become more of a problem, could central bank purchases of debt securities offset a Treasury debt security (and U.S. dollar) buyers’ strike if said strike were due to lost confidence in fiscal policy? At what point does this administration or the next try to restore some fiscal discipline? How does anyone running for office promising fiscal discipline even get elected unless the populace first suffers ruinous inflation coupled with economic contraction?
No, these are not pleasant thoughts. These are however, the thoughts that we must have while we can, well before we must.
I do not know when the debt supercycle will end. I do not know if some new rabbit can be pulled out of a hat. Most middle- and lower-class Americans suffered significantly during the “Great Financial Crisis.” That recession — that crisis — showed signs of its rise as early as 2006. A large swath of American laborers thought the economy was still in recession into 2016, even though the statistical recession ended in 2009. That shows just how tough those years were for most workers. As I just mentioned, I do not know when the debt supercycle will end. I am, however, confident that due to the current U.S. and global political environments, that it will end in crisis.
Cash? Yes…
I have increased cash levels. My cash level is now at 2026 highs. I take no joy in risk management but at times the managing of risk must be prioritized over the seeking of alpha. Fear not. I will still take on targets of opportunity as I see them.
Remember the Rules…
We do not fear… Fear is but for the wicked and the wicked shall tremble before our mighty boots. That said, we are pragmatic and we proceed. We will follow our tried-and-true method, based on the standard military five paragraph order. This will get you through life as much as it gets you through surviving these markets. As we set out, we shall…
Understand… Everything we do, will be done for a reason that we can explain to a novice.
Identify… All avenues of approach, perceived threats and targets of opportunity. Strike with conviction.
Adapt… To all changing environments. Nothing stays the same for very long. Neither do we. Become what is required when it is required.
Overcome… Find a way, even when faced with persistent failure. Getting knocked down happens to us all. Staying down is a choice.
Carry On… Won a few? Lost a few? Big deal. Carry on with the mission. People are counting on you.
Economics (All Times Eastern)
07:00 – MBA 30 Year Mortgage Rate (Weekly): Last 6.78%.
07:00 – MBA Mortgage Applications (Weekly): Last -1.0% w/w.
08:15 – ADP Employment Report (Aug): Expecting 47K, Last 44K.
10:00 – Factory Orders (July): Expecting 0.6% m/m, Last -0.3% m/m.
10:30 – Oil Inventories (Weekly): Last +95K.
10:30 – Gasoline Stocks (Weekly): Last -2.536M.
The Fed (All Times Eastern)
2:00 p.m. – Beige Book.
Today’s Earnings Highlights (Consensus EPS Expectations)
Before the Open: OLLI (1.12)
After the Close: AVGO (3.24), FIVE (1.40), HPE (.93), PVH (3.08), SNOW (.45)
At the time of publication, Guilfoyle had no position in any security mentioned.
