Insights

Chris Watling, Longview Economics

“We are attentive to recent data showing the resilience of economic growth and demand for labor. Additional evidence of persistently above-trend growth, or that tightness in the labor market is no longer easing, could put further progress on inflation at risk and could warrant further tightening of monetary policy.”

The most important price in global financial markets is the US 10-year bond yield.That’s been demonstrated once again in recent weeks, with Treasuries selling off aggressively and causing several assets to reprice. Most notably, US and global equities have fallen sharply, as higher yields have undermined their attractiveness, from a valuation perspective.

A key question in markets, therefore, is: How much higher will yields go? Are they about to top? Or is there significantly more upside to come?

That question, though, and indeed the reason for higher yields, has become the source of much confusion and debate in markets.

Indeed, there are three rationales as to why bonds are selling off.

The first is a ‘fundamentally based’ one. That is, as Powell suggested earlier this month, the US economy is strong, inflationary pressures remain elevated, and so interest rates either need to be ‘higher for longer’, or potentially increased further (see Powell’s quote above). In other words, 10-year yields are driven by growth and inflation expectations and the future path of rates. Reflecting all of that, the bond market is simply returning to its pre GFC crisis ‘norms’, when 10 year Treasury yields were trading between 4% – 5% yields (or even 6%).

It’s normal, in that respect, for 10 year Treasury yields to trend up as the Fed hikes rates (see FIG 1 below). The 10 year yield also typically peaks at around the same level as the terminal Fed Funds rate1 (i.e. currently 5.5% and approx. 50bps above the most recent closing high on 19th October), see FIG 1.

Secondly, there’s the flow argument. That is, according to market chatter: ‘Everyone’s a seller of bonds’. The Chinese and Japanese, for example, are selling their FX reserves/US Treasuries to defend their currencies; US Treasury issuance is large; the Fed is also selling (QT); while hedge funds and algos are jumping on that trade and doubling down on short positions.

Thirdly, and linked to that second argument, there’s the suggestion that the bond vigilantes are back. That is, the market is seeking to discipline the political establishment with higher yields, given: (i) record high US debt levels; (ii) over 10 years of large future fiscal deficits; and (iii) the lack of political will to rein in fiscal profligacy. Or, in other words, the market is looking to ‘charge more for the incremental dollars raised’. In that sense, there’s an argument that the bond vigilantes of the 1970s have returned. This overlaps somewhat with the second ‘flow’ argument above.

Fed Funds: Higher For Longer?

The key question, therefore, is: Which of those three ‘explanations’ is correct? As is often the case, each is probably valid to some degree. We would, though, make two simple observations.

First, the back up in 10 year yields, which began in earnest in early June, has been accompanied by a dramatic re-pricing of interest rate expectations. That is, front end rates have priced out ~100bps of Fed cuts for 2024 (FIG 2). Equally, rate expectations for 2025 made new multi-year highs this month. Linked to that, a strong dollar rally has been underway since mid-July. All of which supports the first ‘fundamentals’ based argument laid out above.

Second, whilst ‘flows’ can influence a price in the short term, over the long term financial markets are about fundamentals and fashions.

Two key fundamental factors, in that respect, point to a rally in bonds (and a pricing in of more Fed rate cuts) in coming months and quarters. In particular, (i) the case for a US recession, probably starting in early 2024 (if not sooner), is growing; and (ii) US inflation should continue to dissipate quickly, see below for analysis of both.

In that scenario, today’s ‘flow’ arguments would likely switch into reverse. If equity markets roll over into a recession driven bear market, for example, investors are likely to sell equities and buy bonds. Equally, the Fed would also stop shrinking its balance sheet/QT (selling Treasuries) and may eventually become a buyer.

US Recession: Incoming

There’s growing evidence in favour of a US recession, which is likely to start within the next six months.

That’s the message of various macro indicators which have a strong predictive power in forecasting recessions, including: i) The Conference Board’s US leading economic indicators; ii) US corporate credit conditions which remain tight and are generally followed by a contraction in commercial and industrial loan growth; and iii) the consumer confidence ‘expectations less current conditions’ index which is currently at low levels, and is consistent with a forthcoming recession. As such, and whilst not all good indicators are signalling that recession call (e.g. the US corporate financing gap), most are.

Added to which, the US yield curve has been inverted for the past 18 months (i.e. 2s10s, amongst others). Curve inversions have forecast all of the past six recessions, with only one false signal in 1998². Usually that signal is confirmed by a contraction in real M1 money supply (see FIG 3). As the recession is about to start, the curve normally steepens up, often sharply. That’s been the experience ahead of all recessions since 1990. Recent steepening of the curve is interesting in that respect and the bears are watching closely³.

Dissipating Inflation & The Age of Monetarism

Monetarism has been out of favour for a long time. In particular, it was increasingly side-lined by major central banks after the 1980s, when targeting money supply growth failed in that decade.

It failed at that time because most of the newly created money, after the deregulation of finance in the early 1980s, was channelled into asset prices, and not the real economy. In particular, newly created money in the commercial banking system found its way into mortgages (and created house price inflation in the 1980s, 90s and noughties). More recently (post GFC), it reached the financial system through the Fed QE programs, generating asset price inflation in markets.

In the 100 years prior to 1963 (which is when Friedman famously said that: “Inflation is always and everywhere a monetary phenomenon”), though, monetarism worked well as a framework for thinking about inflation. That’s evident, at least superficially, from the chart below. Spikes in money supply growth and the big contractions were highly correlated with inflation (i.e. from 1870-1960, see FIG 4).

This latest bout of inflation, therefore, is once again a return to ‘Friedman style monetary inflation’. That is, like the 100 years prior to 1963, newly created money in the pandemic went into household bank accounts through furlough schemes, stimulus checks, ‘beefed up’ unemployment benefits, and so on. In other words, there was ‘too much money chasing too few goods and services’⁴. It's for that reason that we’re back in ‘the Age of Monetarism’ and why the monetarists have been correct with their inflation forecasts, once again, in the past 2–3 years.

Currently, though, major measures of money supply are contracting rapidly in the West. In other words, the risks have switched rapidly away from inflation, towards disinflation (if not deflation).

US Treasuries: Blow off top?

Given that US macro and inflation backdrop, in our view markets are doing what they (almost) always do at the end of sustained moves: The ‘blow off top’ phase.

At those times, prices move away from their fundamentals as herd behavior and capitulation drive a sudden and dramatic final move (i.e. in this instance, as the LONGs panic and close their positions). Usually that marks either the ‘fifth’ or ‘third’ wave in the ‘Elliot Wave’ pattern. In that framework, therefore, this is the final move in yields to the upside.

Equally, and as we have seen with central banks tightening in the past 18 months, the unwinding of 15 years of financial repression comes with significant bouts of volatility as ‘stuff breaks’. This latest round of rising yields is again no doubt ‘breaking stuff’. US regional banks, for example, remain under pressure, as losses in their bond portfolios continue to mount (e.g. see FIG 5). Elsewhere, the impact of high rates on the housing market is likely to be growing, while the share of ‘zombie’ companies in the US is high⁵.

Conclusion

The recent back up in bond yields has been dramatic and has created much confusion and debate in markets. The strongest explanation for the size and speed of the move higher is a combination of (i) ‘fundamental’ factors (largely related to the re-pricing of front end rates); and (ii) ‘technical’ and ‘positioning’ factors which are generating (what appears to be) a ‘blow-off top’ pattern in bond yields.

As such, and while the ‘flows’ reasoning carries some merit, changing expectations about the ‘fundamentals’ will be key for thinking about the direction of bond yields and Fed policy in coming months and quarters. Of note, in that respect, the risk of an imminent US recession is building while, at the same time, there’s strong evidence that US inflation should rapidly dissipate. A re-pricing of rate expectations is therefore likely with more cuts expected to be priced into the curve for 2024 and 2025. All of which creates a strong set up for a US Treasury rally over the next 6–12 months.