(Note: due to the Federal Holiday, this article is posting a day late and provides a summary of the U.S. financial week: October 2- October 6, 2023).
Despite the downward trend in inflation that we are seeing in most of the world, investors in global bond markets -especially those holding in U.S. Treasuries- are worried. They fear ‘higher for longer’ interest rates, an over-supply from a massively indebted government, and possibly monetary financing by the Fed.
While this theme plays out, dollar cash may continue to offer the firm ground for investors.
However, financial history shows the importance of maintaining a balanced exposure to different asset classes, in order to maximise long-term risk-adjusted returns. Investors should sit through the unease on financial markets, to avoid being ‘out of the market’ when sentiment improves.
Fears that interest rates may remain at cyclical highs for some time to come were reinforced on Friday, when strong jobs data was announced. The post-Covid economic cycle continues to be resilient, despite sharp increase in interest rates over the last eighteen months: non-farm payrolls grew in September by 336,000 – this was well above the consensus forecast of 170,000. * The U.S. 10yr Treasury yield rose to a post-2007 high of 4.887% in response.**
Meanwhile, fear of over-supply has been exacerbated by the recent government shutdown crisis. Sure, a shutdown was narrowly avoided. But it once again revealed a deeply dysfunctional political and budget-making system and the solution amounted to little more than kicking the can a little further down the road.
No major U.S. politician appears willing to cut mandatory spending (such as welfare) or defence, which account for around 85% of the federal budget. Meanwhile too many are urging tax cuts or increased government spending. This, when the total outstanding debt to GDP is around 120%**, a peace-time high and the budget deficit is around 5.9%, the largest of any major economy by some margin.
Bond investors fear the solution will be monetary financing of the deficit: the Fed simply buys Treasuries, as it did under quantitative easing.
But this time it will not be to avoid recession during a period of weak inflation. Instead, it will be to allow the government to avoid taking hard decisions at a time when inflation (i.e., too much money chasing too few goods) is already a problem.
In response to these issues, bond investors are demanding higher yields for all maturities of government debt. This then pushes down the relative attractiveness of other asset classes, such as equities. But yields are not increasing at an equal rate along the curve…
The bear steepener
The U.S. Treasury yield curve is dis-inverting, as longer dated yields climb faster than short-dated. The spread between 2yr and 10yr yields has gone from a peak of minus 1.06% in late June, to just 0.3% today. A normal sloped yield curve may be with us soon.
But this does not mean that investors can sleep easily, reassured that normality is returning to fixed income markets because macro-economic conditions are normalising.
That might be the case if the yield curve was dis-inverting because of a ‘bull steepening’ trend -whereby short-term rates fall, but long-term yields remain anchored.
A ‘bull steepener’ is often associated with periods when the Fed is cutting interest rates, in response to falling inflation and weak growth and investors start looking ahead to a new business cycle. It is the anticipated acceleration of growth and inflation, some years ahead, that keeps longer-dated yields up.
Instead, the Treasury yield curve is undergoing what is described as a ‘bear steepener’, in which long term yields rise relative to short-term yields, which remain fixed. Because of fear of long-term sticky inflation (future inflation expectations are likely to come into play in negotiations the longer inflation persists and become self-reinforcing) and from fear of oversupply from an indebted government resulting in the Fed printing more money.
In other words, from the point of view of most investors, the Treasury yield curve is dis-inverting for the wrong reasons. Instead of indicating a return to the start of a normal economic cycle, it indicates an approaching day of reckoning for Capitol Hill as so-called ‘bond vigilantes’ demand an-ever-higher premium against stubborn inflation and over-supply.
So why a stock market rally on Friday?
Despite the rise in Treasury yields, and the dampening effect that higher bond yields have had on investor sentiment for stocks in recent months, the S&P500 rose 1.2% on Friday. Why?
Stock market investors focused on the positive aspects of Friday’s labour market data, that included flat unemployment at 3.8%. The longer the post-Covid economic cycle persists, the better for corporate earnings. It seems that, once again, stock investors were choosing to see the story suited them best. Their natural optimism may struggle against the ‘bear steepener.’
***Based on an estimated U.S public debt of $30 trillion at end 2022, by the Federal Reserve Bank of St Louis.
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