Bond Markets Revisited

I make no apology for writing an article on bond yields only six weeks after I last wrote on this subject.  The recent rise and the impact of higher yields on governments’ cost of borrowing has now made the headlines of even the lay press, often in apocalyptic phrasing.

Yields are rising

A lot has happened since I last wrote.  By rising to the highest yield levels for nearly 30 years bond markets have given the kind of unintermediated signal which the Chair of the Federal Reserve, Kevin Warsh, said he wanted.  Inflation remains at elevated levels, with little sign of any prolonged slow-down.  Governments on both sides of the Atlantic seem unwilling to come to grips with precarious fiscal arithmetic.  The wars in Ukraine and the Middle East rumble on.

Most commentators conclude that there will be a reckoning between bond markets and politicians sooner or later and that the former will win.  In essence, governments will be unable to finance its debt at an affordable cost and will have to come to heel (or possibly go down a more desperate path of default or unfettered inflation).

Lack of fiscal credibility is not really the reason

However, the data doesn’t really bear that interpretation, at least at present.   Who knows what the future may hold?  Yields are rising, but most of it can be accounted for by the rise in expectations of higher short-term interest rates.  The residual is the term premium, the excess yield resulting from either supply/demand imbalances or compensation for uncertainty and political risk. 

This term premium has hardly risen over the past 18 months (at the ten-year tenor) in either the U.S. or most other G7 markets.  That suggests the explanation lies elsewhere.  Interestingly, the U.K. is an exception, perhaps reflecting the lack of credibility of successive governments including the current one.

I believe the reason for higher bond yields is simple.  For the first time in three decades, there is a capital investment boom.  The hyperscalers such as Amazon and Google are in aggregate planning to spend almost all their cashflow on capex over the next few years and have turned to debt markets.  The sums over the next five years mount into the US$ trillions, not far off the U.S. government’s primary deficit.  This competition for investors’ money is a major factor behind higher yields along the curve.

Bessent and Warsh are achieving their objectives

In my view Bessent and Warsh are largely succeeding on their own terms.  The Federal Reserve’s remit is to maximise employment, while keeping prices stable (interpreted as an average rate of 2%) and long-term interest rates moderate.     

There is no policy action that either of them can take which will at a stroke reduce inflation from the current well above target levels.  President Trump seems to have reluctantly accepted the recent rate rise, but is unlikely to endorse further increases.  So it seems eminently sensible to let the bond markets do the heavy lifting by sending a message to politicians. 

At the same time, the financial markets are being kept orderly by repressing volatility along the curve.  At the longer end the Treasury is buying back bonds, albeit not much more than 0.1% of the total long term Treasury issuance of around US$5 trillion.  This prevents a repeat of any 2022 Truss moment when bond values (NB, not yields) fell so fast that the U.K. gilt market became disorderly.  

At the shorter end, the U.S. is providing liquidity to ensure there is sufficient collateral and no disruption in the reverse repo markets.  I come back time and time again to these because they are where strains will show first.  Since January the overnight rate has traded closely in line with the Effective Federal Reserve rate, suggesting that avoiding stress here may be an explicit policy objective.

Bessent’s primary objective at the Treasury is to finance or refinance the U.S. Government’s growing debt pile at a reasonable cost.  I have previously commented on how he has turned to financing through shorter term bills rather than longer term bonds.  This helps the optics, because bills with a tenor of less than two years are sold at a discount rather than paying a coupon.  They therefore don’t count towards any debt service cost calculation. 

There is a good article in the weekend Financial Times Wall Street expects US to issue about $1tn of short-term debt as borrowing costs climb with historic data on this subject.  The current tilt towards using bills rather than notes or bonds is not unprecedented at all, but it is a shift from the recent past. 

What is not to like?

So, what is not to like?  In a good world, rising bond yields rein Trump in while markets remain orderly and high nominal economic growth fulfils the Fed’s employment objective.  Plenty of liquidity provision at the short end prevents financial crises.  Inflation running a bit above 2% reduces the real value of government debt and interest rates don’t have to rise much.  Deflationary consequences from AI may even bring inflation down.

For investors, the world is less rosy-hued.  At a high level, market capitalism appears to be morphing into something new where financial markets are sublimated to the activity of states.  The old frameworks of law and regulation are weaker, and states play a larger role in society and economies.  Financial markets are a tool that they will increasingly use.

Nearer home, Bessent is pumping money straight into the real economy by keeping overnight rates lower than they should be.  That will not help assets in the way that the 2010-2020 period of Quantitative Easing, which reduced rates right along the yield curve, did.  The difference can be seen starkly in bond yields – around 1% then and 5% to 6% now – and the much higher nominal economic growth rate today.  Financial asset prices are falling, while the economy is much stronger, whereas ten years ago the reverse was true.

These higher bond yields must additionally have a negative impact on the valuation of longer-term financial assets, whether real estate, equities, infrastructure, or alternatives such as cars or wine.

Today, liquidity is flowing into the economy, largely as AI cap ex.  But the economic cycle has not gone away and current economic strength will inevitably diminish in the future.  When capital investment fades, some of the excess liquidity, not needed for investment in the real world, will start again to flow into financial assets. 

Stratagems to protect wealth

How should investors act to protect their wealth?  Some suggest physical gold, but it is easy for a state to confiscate that, as the U.S. did under Eisenhower in 1933.  It may be that commodities more generally, where supply is at risk in a less peaceful world, is part of the answer.  Or it may be currencies in those countries where the authorities have not gone down the primrose path of easy money.  Think the Swiss franc most obviously, but perhaps also some of the emerging markets.

Index-linked bonds will provide some protection and provide a 2.5% return above inflation.  But linkage to consumer inflation will not necessarily protect against asset deflation.

Or it may be a question of timing i.e., accepting that in the short term nothing will protect your assets, but holding liquid assets and being ready to purchase assets as and when the pricing becomes more realistic. 

I am open to better suggestions from readers.