A large contingent of the bond bulls coming into this year made their case based on the perception that the economy could not handle a 10-Year Note yielding north of 3.5%. Once this level was surpassed, they then pegged 4% as the line in the sand for this highly-levered economy. As the 10-Year yield hugs 5%, maybe these same bond bulls are coming to understand that they had the causality wrong. The economy adapts to the prevailing rate of interest and not the other way around. Thus far, rates have clearly not been prohibitive enough to slow the economy down substantially.
Much has been made about what the term premia should be in the Treasury Market, however we would argue that the whole thing is an exercise in minutiae. Some argue that a larger portion of the risk premia should be attached to inflation, while others speak to the U.S.’ ever-growing debt and deficit problems. We say it is all irrelevant. It is our core belief that the Fed has effectively lost control of the bond market and the latest call by Fed officials to allow the market to do its dirty work is the exclamation point on years of reckless mismanagement. It is not a coincidence that these statements coincided with a rapid escalation in the fixed income selloff.
In our estimation, the market has a deep sense of suspicion for this newfound policy symmetry, and it knows that once the Fed senses even the hint of crisis it will stand at the ready to cut rates (per usual). The distrust lies in the fact that the undertaking of extraordinary policy measures (either overt or otherwise) will inevitably involve the sacrificing of its inflation fighting mandate for the systemic greater good. The markets have heard the Fed cry wolf enough times in these efforts and, as such, there is the potential for Powell & Co. to find itself battling a systemic crisis alongside a falling bond market.
While it almost seems inconceivable that bonds would not perform their usual flight to safety function in the event of some type of market “event”, add this to the long list of things that we once thought unthinkable (Fed buying individual corporate bonds which violates The Federal Reserve Act, GFC, Covid lockdowns, etc.). It should also be noted that Treasuries failed to rally post-SVB and saw lackluster bids after the recent attacks in the Middle East.
We continue to skew bearish on bonds for the medium and long term. That being said, a short-term rally should not be ruled out given the pervasive level of negativity in the market. However, the recent Barron's headline title “Time to Buy Bonds” should strike fear into any potential bond buyer.
If you are looking for another data set that underscores the shift in the long-term trend, look no further than what’s transpired throughout most of this year. Treasury yields climbed for a sixth straight month through October, something which has only happened six other times over the past 61 years. Additionally, during this six month stretch, the yield on the 10-Year Treasury has gone up 140 basis points, a record increase dating back to 1962.
We write this commentary on Fed decision day and to no one’s surprise the policy rate was left unchanged. However, they did make a point to acknowledge tighter financial conditions and that they see the increase in long-term Treasury yields as “likely to weigh on economic activity”. The Fed further stated they believe the jump in yields is due to a rise in the expectations of the policy-rate floor. In addition, Powell felt that the progress on inflation will be “lumpy” ( yes the term lumpy has now joined the financial lexicon).
Takeaways: The Fed has publicly acknowledged that the bond market is now steering the ship. Market participants should buckle up as free markets act much differently than Fed policy where forward guidance is designed to ensure that there are never any surprises. Under this new market-driven policy, there will not be any such guardrails.