Different This Time? Or Not?

The headlines are full of the financial problems which governments face, as they increase spending on defence and health without taking the political pain of raising taxes or cutting spending.  The United States is on its own different path but has the largest budget deficit of all.

U.S. is back to a policy of QE

Long-term bond yields have accordingly continued to rise and the U.S. 30-year bond has been bouncing around 5%, while in the U.K. the equivalent bond is now at 5.5%.  But it is only at the long end; at the 5-year tenor yields have fallen by more than 100bps since October 2023.

The U.S. Treasury has reacted by financing much more at the short end of the curve.  Almost a quarter of funding in the last 30 months has been at under 12 months maturity - i.e., T-bills rather than T bonds.  It is not just that the funding rate is lower, and less issuance of long-term bonds suppresses yields, but non-coupon bearing T bills do not appear on the debt service bill.  If the authorities were not doing this, the latter would be even higher than the US$ 776bn in the 12 months to May 2025 - 16% of total Federal spending.

The road to the magic money-tree

The practice began with Janet Yellen but has continued under Scott Bessent.  It may be the least bad of the options he has to try to keep the U.S. Government finances on the road, but it is still the road to the magic money-tree.  He had a reputation for believing in sound money, and for a few weeks we at Linchpin thought he might try a different tack, but that has so far proved not to be the case.

Funding short-term solves the Treasury’s short-term problems but piles up the long-term ones.  Not only do T-bills have to be refinanced within 12 months, but it is effectively, as my friends at CrossBorder Capital have long pointed out, another form of Quantitative Easing.  It can be thought of as Treasury QE, because the effect is to cut out the first two stages of the more traditional Central Bank QE we saw after the Global Financial Crisis.  Instead of issuing bonds and buying them back using short-term finance, they are just issuing T-bills.

The clear implication is higher inflation in the longer term.  At Linchpin we have been warning about this for many years.  See our latest annual inflation indicators survey here.  We wobbled this spring when Bessent came in, because we thought he stood for sound money, but we have gone back to our long-term view.

How high will bond yields go?

There are two huge questions for investors coming out of this.  One is how high long-term bond yields will go.  The second is why are equity markets so close to all-time highs against the grim background of deglobalisation, low growth and higher bond yields.  The rest of this article looks at each of these in turn.

I will start with bond yields.  Conventional thinking is that they must go higher as the bond vigilantes, those financial folk-lore heroes (or villains, depending on who you are) react to higher supply, higher inflation, and lower government credibility.  CrossBorder Capital calculate from agency debt backed by the Federal Reserve that U.S. Government bond yields are currently about 80bp lower than they should be.  The reason is financial repression as described above.

At Linchpin we agree yields should be higher and the pressures may indeed lead to further rises.  But there is a clear limit to the debt service costs which governments can afford, and regardless of the quantums the cost will rise regardless.  As evidence for the upwards pressure, the average cost of U.S. debt rose from 1.6% to 3.2% between 2021 and 2024.  So we are expecting further forms of repression as cheap debt is financed at higher rates. 

Yield suppression to trump fundamentals

We believe the U.S. Treasury will therefore find ways to suppress yields, as they are doing now.  Trump has floated the idea of U.S. allies taking strategic positions in U.S. bonds, and capital controls of some sort may make a comeback.  We suggest that the current 5% is not too far away from the upper yield level which can be tolerated.

What about the U.K?  The Office of Budget Responsibility has this week warned about the U.K.’s level of public debt and its inability to respond to any fiscal shock.  Despite the Government’s recent U-turns on social spending, the U.K. fiscal arithmetic is not quite in as bad position as the U.S, but U.K. bond yields inevitably hang off the coat-tails of the U.S.  And we are not in a position to ‘demand’ that allies buy our debt.

Against this background, why is sterling so strong?  The glib answer is about dollar weakness and relative interest rates – as so often our rates are higher than most of the world’s.  But perhaps the real answer is that other countries, most notably the U.S., face similar issues to the U.K.  The uninviting prospects are common, so there is no reason to single sterling out.

Equities are seen as the least bad alternative

Turning to equities, many are surprised that they are close to all-time highs given the back-drop of low growth, more volatile geo-politics, and valuation levels.  In our view there are credible explanations, but it is open to question whether they are sufficient to justify current levels.

The first explanation is the expectation that lower interest rates will stimulate stronger demand.  We have seen rate cuts from a number of central banks, but they have had no effect on economic growth.  We would categorise this explanation as the lazy one – what commentators use when they can’t think of another reason.

A second explanation is that U.S. earnings growth has been resilient at about 5% (year on year) in the second quarter.  At Linchpin we doubt this is sustainable for long against economic growth of 1 to 2%.  Somebody must be eating somebody else’s lunch, and that cannot carry on for ever.

Another is that equities are favoured because they look more attractive to investors than the alternatives.  Bond yields are repressed (as above), and there are question marks over the valuations of many alternatives under the new financial environment.  Or it may just be that investors are ‘buying the dip’ because it has worked every time over the last 30 years. 

We have more sympathy for this last explanation.  One reason why ‘buying the dip’ has worked is because for most of the last 30 years, and especially the period since 2008, we’ve seen substantial liquidity creation.  The excess money created has flowed into financial markets and boosted (among others) both real estate and equity prices.  Here we are back in a QE world, so nobody should be surprised that equities are buoyant.

Don’t forget market cussedness either

We would also comment from experience that markets like to wrong-foot investors.  The formal explanation might be more about the dangers of investing alongside the consensus i.e., being the last man into the trade.  Back in April this year, many investors – and we have to include Linchpin in this – believed that this time really was different, and ‘buying the dip’ was wrong.  We may yet turn out to be justified in our view, but in the short-term the market has certainly decided to make life uncomfortable for those of us who were cautious in April.

But valuations remain high

None of these explanations get round the awkward fact that U.S. equities, some 70% of the global index, are expensive when compared both to their own history and to the rest of the world.  Earnings growth may have reduced the valuation premium slightly, but they still stand at a near 25% PER premium.

Not different this time either? 

We are left asking whether equity bulls or bond bears are more likely to be proven right.  Bond markets have historically been better predictors, but can their signals be relied on when they are being so distorted by the activities of the authorities? 

Behind that the fundamental question is whether the bond vigilantes could break the U.S. Treasury’s grip and send bond yields much higher.  If bond-markets are able to resume their historic place as intimidators* in chief, then they could and should. 

But it is a brave investor who bets against the U.S. authorities.  So until the next twist in the road, at Linchpin we believe we are back to the world of QE and the magic money-tree.  That is supportive for financial markets, at least until it isn't.  So perhaps the next page does not look so very different from the last 30 years.

* Bill Clinton’s chief strategist James Carville famously said in the early 1990s: “I used to think that if there was reincarnation, I wanted to come back as the President or the Pope or as a .400 baseball hitter. But now I would want to come back as the bond market. You can intimidate everybody.”