In the past weeks, markets have witnessed an increasing level of stress on bonds, particularly at the “long-end.” There have been numerous interpretations primarily concluding that the market is re-pricing the risks of persistent inflation, heavy government borrowing, uncertainty around energy prices, and even the lack of forward guidance from the Fed itself.
Around the July Fed meeting, the 2-year yield was about 3.90%, the 10-year 4.61%, and the 30-year 5.09%. By August 11, the 2-year had edged down to 3.83%, while the 30-year had climbed to 5.25%. In the following week, the 30-year briefly reached roughly 5.33–5.34%, its highest since 2007; the 10-year touched about 4.75%. [Data source.]
Two supposed “surprises” seemed to rattle markets:
Chairman Warsh’s determination to limit the use of “forward guidance”, also known as his “less-guidance” stance. (Why this would be a surprise is strange, since Warsh forecasted his position about reducing forward guidance months before.)
Treasury’s announcement that it would buyback more long-dated debt, played out well initially, but then failed to convince the market.
Market dismay over the state of long bonds seems to rely largely on the most obvious interpretations mentioned earlier. But, what if there is more to the recent upheavals in the bond market?
Bond Market Chaos
The Wall Street Journal’s Joseph Sternberg posits that Kevin Warsh’s plans are actually proceeding the way they should be. From what I have assessed of Chairman Warsh, he is playing a long game that will likely present seemingly chaotic conditions—organized chaos— in order to achieve his aims; the main one being “shrinking the Fed’s balance sheet,” which ballooned out of proportion under Quantitative Easing (QE). Add to that goal an over-arching aim to return the function of The Federal Reserve back to its original mandate.
[For clarity on the impact of Quantitative Tightening (QT), watch or read this.]
What some will interpret as “failure” at his job is more likely a calculated re-direction towards how markets traditionally operate. In essence, Warsh is standing the Fed aside, allowing markets to price risk. “The result is a world where companies and investors are newly able to price risk in line with expected economic growth.”
Or to put it differently, the market is reclaiming the job of pricing government debt after years in which central-bank purchases, near-zero rates, and strong Fed guidance suppressed yields. Reuters describes this current shift as an effort to let the bond market do more of the price-setting work. And that’s what markets are starting to do, albeit with supposedly less clarity on “expected economic growth.”
Losers & Winners?
In the short run Lawmakers appear to be the biggest losers. They will have to pay more to borrow. Yet, in the long-run there is an opportunity for market-driven rates to result in a big win for Lawmakers—by stimulating fiscal responsibility!
Sternberg argues:
The most convincing explanation for the surge in yields is an uptick in expectations for future economic growth. This is manifested by the willingness of tech companies to bid up interest rates as they borrow to invest in artificial intelligence.
It’s the latest sign that “financial repression” is unwinding, and not a moment too soon. The term refers to a suite of economic policies (the details vary at different times and places) designed to allow the government to borrow at below-market rates, at the expense of savers and with woeful distortions throughout the economy. This has been the dominant policy mode across the West since the 2008 financial panic.
True. QE and very low rates made it cheaper for Congress and the executive branch to run large deficits and refinance existing debt—effectively a subsidy. By buying Treasuries and suppressing long-term yields, the Fed reduced the immediate budget cost of borrowing. A result which weakens the political pressure to restrain spending, or make difficult fiscal choices.
But the Fed’s stated purpose (behind QE) was macroeconomic stabilization. So, “subsidy” is a fair description of the economic effect, particularly when inflation-adjusted yields are below market-clearing levels. However, less fair as a claim about the Fed’s formal objective or a direct political arrangement.
The current rise in long-term yields is a reverse sort of pressure: markets are charging the government more for borrowing, making fiscal choices harder to defer.
In the long-run that should be a good thing. However, anticipate more “adjustments”, as Sternberg puts it. Necessary decisions often make for a bumpy ride. And, in my opinion, the Fed Chairman needs to be clinically decisive.
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