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A bond vigilante is a bond trader who threatens to sell, or actually sells, a large amount of bonds to protest or signal distaste with policies of the issuer. US Treasury bonds are under siege from bond vigilantes. When bond prices drop the yield goes up.
The 10-year US Treasury bond yield, the benchmark for the global cost of capital and the basis for valuing all financial assets, has surged over the past quarter, touching 4.87% on Friday 6th October from 3.84% on 30th June. Rising bond yields increase the required rate of return from equities, putting pressure on share prices. As well as placing downward pressure on the pricing of global assets, rising Treasury bond yields also sap global liquidity. Global liquidity is crucial to keeping financial assets buoyant.
What are the bond vigilantes so uptight about? The US federal budget deficit has risen to almost 6% of GDP, which is not unprecedented, but it is normally elevated during recessions, not when the economy is robust as it is currently. Among major economies, the US budget deficit is exceeded only by Japan. According to the Congressional Budget Office (CBO), the federal budget deficit could hit 10% of GDP by 2053 if current revenue and expenditure trajectories are maintained. Deficits need to be funded with debt. The CBO projects the debt/GDP ratio will double by 2053 to 180%. Net issuance of new Treasury bonds year-to-date already marks the second highest year on record after 2020 when the Covid pandemic fiscal rescue package was launched. Treasury issuance is expected to rise by over 20% in 2024. Fitch rating agency downgraded US sovereign credit risk on 1st August.
With all the talk of bond vigilantes, the main reason for the spike in Treasury bond yields is Federal Reserve policy. At the Fed’s last policy meeting, which concluded on 20th September, the chairperson Jerome Powell acknowledged that interest rate hikes had not slowed the economy as much as anticipated in order to bring down inflation. The Fed signalled one more rate hike to come and only two rate cuts in 2024, versus four cuts that it had previously indicated. In other words, the Fed cautioned that interest rates would stay higher for longer. The 10-year yield rose sharply over the following fortnight from 4.34% on 20 September to 4.87%, causing apprehension in global financial markets. G7 sovereign bond yields increased in unison. Some fear that having failed to predict the surge in inflation, the Fed is intent on restoring its credibility and will be too restrictive in its policy.
There are contrasting views. On the one hand, some economists championed by former Treasury Secretary Larry Summers believe interest rates are still not high enough to threaten economic expansion and so bring inflation back down to the Fed’s 2% target. According to independent research company MRB Partners “Long-term bond yields across the major economies have not yet reached a level that will trigger a recession…. Continued economic expansion points to further upside for the US 10-year Treasury yield.” Other economists believe that due to the lag time between interest rate hikes and economic slowdown, it is only a matter of time before the US enters recession. Another independent research company, Capital Economics says that “monetary lags are famously long and variable, and we estimate that around half of the impact of central bank tightening in this cycle has yet to be felt in the real economy. The next show to drop will be a rise in debt servicing costs on existing debt as fixed rate loans taken out in recent years expire and borrowers are forced to refinance at higher rates.” The average rate on new 30-year fixed rate mortgages in the US has already climbed to 7.8% from 3.1% at the end of 2021.
The debate centres around where the neutral fed funds rate lies. The neutral rate is the real fed funds rate (the nominal rate minus the inflation rate) which neither restricts nor stimulates economic growth. In the 15 years following the 2008/09 Global Financial Crisis (GFC), the neutral rate fell compared with previous years due to widespread deleveraging in the private sector. Although a subjective reading, the Fed set the neutral level at 0.6%. Some argue that the neutral rate has increased due to the post-GFC deleveraging and repaired private sector balance sheets. If US CPI settles at 2.3% as indicated by the Treasury Inflation Protected Bond 10-year breakeven rate, the real fed funds rate is currently 3% (the 5.25-5.50% nominal rate minus 2.3%). This is significantly above the longstanding neutral rate of 0.6% and even allowing for some upward revision to the neutral rate, suggests the Fed is already highly restrictive in its monetary policy.
All of this suggests that the Fed is unlikely to hike further and that it is already past the peak in the rate hiking cycle. If so, the 10-year yield, notwithstanding the bond vigilantes, will come down once it becomes clear that the Fed has pivoted towards an easing in monetary policy. Over the past eight Fed monetary tightening cycles, the 10-year yield fell by an average 130 basis points in the six months following the last interest rate hike. If the latest rate hike in July turns out to have been the last, as seems increasingly likely, we should expect a retreat in bond yields soon, which would support equity markets. Largely rising Treasury bond yields are doing the Fed’s job for it, which explains the drop in probability, since yields spiked higher, ascribed to a further rate hike. Fed funds futures are now ascribing a 10% probability to a further rate hike before year-end, down from 50% two weeks ago. San Franciso Fed president Mary Daly said that “If financial conditions, which have tightened considerably in the past 90 days (higher bond yields), remain tight, the need for us to take further action is diminished.”
• All writers’ opinions are their own and do not constitute investment recommendations or financial advice. Speaking to a qualified wealth and investment professional is crucial before making financial decisions.
• ‘Overberg Asset Management (Pty) Ltd. is an authorised financial services provider: 783’ established in 2001.
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