It would appear that the Fed has woken up to the concept of free and open markets with several Fed Governors recently expressing that markets should assume the heavy lifting of further rate increases. This new form of forward guidance allows the Fed to appear tight while letting the market mete out that tightness, if it so decides. If this is their non-strategy, then we anticipate even higher volatility in the days ahead than we are experiencing now. In fact, the volatility in bond returns vs. equities is reaching levels rarely seen over the past several decades.
We must give the Fed a lot of credit here for its timing. Heading into an election year, it is choosing the politically expedient path and letting the market do its dirty work. As we have written about extensively, rates are most likely headed higher as duration goes looking for a home. The price insensitive buyers such as the Fed, commercial banks and foreigners have hit the exits while domestic buyers have chosen to sit primarily at the front end of the curve. The 30-Year auction last week should be looked at as a precursor of what is to come (a benign CPI number followed up by very weak demand at auction) as supply meets demand at ever higher and higher rates.
Does this sudden swing towards a market-based policy mean that the Fed has essentially said “close enough” when it comes to inflation? If so, it comes at an odd time given that the recent PCE print on a year/year, 3-month/3-month, and 6-month/6-month basis all exceeded the targeted 2% for a record 30 months. The longest such streak prior to this was only six months. This pause potentially represents one of those “premature celebrations” we wrote about in an earlier commentary. We would highlight however, that these kinds of early exits were predominant in those “unsolvable periods” where inflation remained persistently high.
Regardless of who’s in the driver’s seat, rates continue to grind higher as inflation stays above target and the dysfunction in Washington becomes more and more acute. What’s notable about this most recent selloff in the bond market is that it comes at a time (immense conflict in the Middle East) where you would typically see flight-to-safety buying across the entire curve. The fact that you are not witnessing buying, but rather heavy selling, should make bond bulls question their underlying thesis.
The bond bulls are undaunted however, particularly if you look at the inflows into “TLT” (the iShares 20+ Year Treasury Bond ETF) YTD. Despite the unceasing losses, fund flows into the TLT have remained remarkably strong. While TLT buyers may have taken a page out of the “ARKK” purchasers playbook, we might suggest to these unabashed bulls that there is nothing lurking (such as NVDA or TSLA) in the TLT portfolio that will miraculously levitate the ETF’s returns.
There are, however, a number of things looming over the horizon that could inflict further pain, and it may come under the guise of refinancing. Apollo Global Chief Economist Torsten Sløk points out that 31% of the U.S. debt outstanding, or $7.6 Trillion, will come due next year. This rollover will come on top of the anticipated $3 Trillion deficit financing that most assuredly needs to take place.
Takeaways: The “higher for longer” crowd is currently beating the “lower sooner than later” bunch. The decades-long period of managed rates close to the zero bound went a long way towards covering up the issues associated with running massive fiscal deficits. The simple math that accompanies today's fiscal irresponsibility ($2 Billion per day in interest costs for existing debt) means that the available road for further consequence-free “can kicking” has essentially run out.