Bonds are boring they say. Like watching paint dry. If you want excitement buy a tech stock. If you want slow and steady, but a Treasury. Oh, how wrong they are!!! The price on the 10-year Treasury bond has been whipping around like a money losing start-up….which in a way a government bond is (money losing, not a start-up). Long-term government bond prices rallied over 5% in one week. One week!! The yield on the 10-year has fallen roughly half-a-point in a couple weeks. You don’t see moves like this very often.
Of course, there’s the story as to why yields declined (and stocks rallied), and then there is the story behind the story. Let’s start with the straightforward bit. The Fed met this week and decided they had done enough for now, and today’s employment report only solidified this view.
There are a few reasons they are taking the ‘discretion is the better part of valor’ path. First, long-term interest rates have gone up a lot. You can see below that the yield on the 10-year flirted briefly with 5% only a few days ago.
This move is doing some of the Fed’s job for them as numerous financing costs are tied to long bonds. Car loans, mortgages, the loan on that apartment building down the street, even the cost to finance a start-up business.
Secondly, inflation is sort of moving in the right direction. The headline CPI is down a bit, but strip out housing and inflation is at the Fed’s target.
Granted, the growth data in the third quarter was robust, but the early guess for the fourth quarter is much less exciting, as you can see below.
And the employment picture is starting to soften just a bit. A relatively modest 150,000 jobs were added last month, and prior reports were revised lower. Additionally, the unemployment rate ticked higher again to 3.9%. It is now a half-a-percentage-point above its cycle-low from earlier in the year.
A more accommodating Fed puts people in a buying mood, at least that’s what the playbook says.
The Story Behind the Story
Of course, no one can ever be sure why the markets do what they do, but we’d contend there’s another factor at play. Let’s step back for a minute. Harken back to early August – lazy summer days, vacations, and the realization that this year’s F1 season is a snooze fest. But August 2nd is also when worries about funding the U.S. government flared up in a big way. Headlines blared that deficits are out of control and there’s a tsunami of new bond issuance coming down the pike.
And the headlines weren’t wrong. On August 2nd the Treasury announced their funding requirements for the third quarter of 2023. It was a big number – right around $1 trillion. Bond yields spiked higher.
This isn’t a new story of course. For example, the total amount of U.S. Treasuries held by the public rose to a record $25.7 trillion in September. This series is up $9 trillion since January 2020, and has quintupled since the financial crisis. But the rate of change seemed to be accelerating.
But this week the worry started to abate for a couple reasons:
- First, the US Treasury announced its borrowing estimates for Q4-2023 ($776 billion) & Q1-2024 ($816 billion). These are big numbers, but less than analysts were expecting.
- Then on Wednesday the Treasury said how their borrowings in Q1 were to be financed. 58% of funding needs would be through short-term Treasury bills, not long-term bonds. This is a huge shift from the typical mix of 15% to 20% short-term funding. This news kicked off the big rally in bond prices (fall in yields), as you can see below.
Why? Fewer long-term bonds issued means less supply and less pressure on yields. The market was priced for a tsunami that isn’t going to materialize, at least not in the first quarter next year.
Of course, there’s a good news/bad side to this change:
- The bad news is that the Treasury is going short because they are worried there isn’t enough demand at the long end. Investors don’t want the long-term risk of being debased by inflation.
- The good news (for now) is that issuing short-term bonds to fund deficit spending is like tapping the overdraft line of credit to pay for a vacation. It’s stimulative for the economy in the short-run and doesn’t have the effect of driving up long-term interest rates and slowing growth. No crowding out so to speak.
For now, the markets like the tradeoff. But the risk for next year will be a resurgence in inflation. Bonds are going to be far from boring in the months to come.
(Other) Charts We Found Interesting
- Another inflation chart – on the path towards 2% or the lull before a resurgence?
- This is one way of showing the so-called equity risk premium – short-term bond yields exceed the earnings yield on the S&P 500 for the first time in decades.
- The outlook for fiscal policy will be a big factor at play in 2024.
- At one point WeWork had a valuation of $47bn. It will probably go bankrupt this month.
- There’s always a bull market somewhere – orange juice edition.
- Brings back memories of Trading Places and Randolph and Mortimer Duke – ‘looking good Billy Ray – Feeling good Louis!!’
Have a good weekend
Charles Blankley
Principal
Chief Investment Officer
Gemmer Asset Management LLC
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