Treasury bonds are falling at the fastest pace in nearly two years this month, with yields surging to multi-decade highs amid renewed inflation concerns, a hawkish Fed, a resilient domestic economy and mountains of new supply.
Call it a meltdown. Call it the end of 'free money'. Call it the result of a recession escape that would make Houdini look envious.
Just don't call it a bubble.
Woody Allen makes a wonderful analogy about love at the end of 'Annie Hall', through an old joke about two ladies complaining about their resort in the Catskills.
"The food here is just terrible," one says to the other. "Yes, I know. And such small portions," her friend agrees.
Understanding that paradox gives you a much better insight into what's happening – and, perhaps more importantly, what isn't happening – in the world's biggest financial market.
Treasuries can look unappealing, at best, and downright lethargic at worst, but it doesn't change the nature of their demand, which remains relatively constant, regardless of the returns on offer.
They may taste bad, but everyone wants bigger portions.
Data published late Wednesday, in fact, showed that foreign investors ramped-up their holdings of U.S. Treasuries to the highest levels in 18 months in August, hovering up $7.707 trillion worth of Uncle Sam's bonds in a month when 10-year yields moved no more than 3 basis points over the 30 calendar days.
Even a notably 'weak' auction of $35 billion in 10-year Treasury notes earlier this month, just as the surge in rates was picking up pace, drew $87.5 billion in overall bids, with foreign investors taking down around 60% of the overall total.
Function over form
The $25 trillion Treasury market performs an incredibly important function in financial arithmetic by providing a proxy for a "risk-free" interest rates that can be applied to any kind of asset.
Beyond that, foreign buyers, often central banks, are merely exchanging dollars earned in trade with the US (which carry no interest) into Treasury bonds backed by those same dollars (which now provide a health risk-free return).
Japan, the biggest foreign buyer, boosted its August purchases by an annualized rate of 3.4%, to $1.116 trillion, even as its own central bank was making plans to increase returns on Japanese government bonds.
It's worth noting, too, that Japan's exports to the U.S. rose by 5.1% in August, boosting its trade surplus by 38.2% to ¥650.60 billion ($4.33 billion).
Those numbers, while wonky, go a long way towards debunking the notion that Treasury bond markets are some sort of "bubble" that's likely to pop if yields continue to rise.
While stocks, currencies, crypto and, for that matter, corporate debt, can offer the promise of returns that simply aren't guaranteed, the two central promises they carry – that the government will pay you interest on the money it borrows from you and will make you whole when the bonds mature – never deviate.
Mark-to-maturity, not the market
Mark-to-market losses, as Bank of America's third quarter earnings report indicates, can cause some alarm, but CEO Brian Moynihan correctly noted that the banks bond holdings are the result of putting depositors money to work (not unlike trade balances) and the bulk of the assets are in a "held to maturity" account with little or no risk. These are government-guaranteed securities," he told CNBC.
All that said, where we go from here is anyone's guess, as evidenced in Thursday's speech from Fed Chair Jerome Powell to the Economic Club of New York.
"We are attentive to recent data showing the resilience of economic growth and demand for labor" Powell said, after weekly jobless claims data showed another surprising pullback in the number of Americans filing for unemployment benefits. Labor Department figures published earlier this month also noted that 336,000 new jobs were added to the economy in September.
That economy, in fact, is now growing at a 5.4% clip, according to the Atlanta Fed's GDPNow forecasting tool, challenging the conventional wisdom on Wall Street that the U.S. would be in recession by now.
All that growth, of course, comes at a price, and inflation pressures are building once again, as evidenced by the bigger-than-expected jump in September retail sales and the hawkish rhetoric from Federal Reserve officials heading into next month's policy meeting.
The CME Group's FedWatch suggests a 48.5% chance of a rate hike in January, with the odds of a move prior in December pegged at 37%. Traders, however, fully expect the Fed to hold rates steady at between 5.25% and 5.5% next month in Washington.
Bonds will also be pressured from a host of other factors, including concerns over the fate of U.S. fiscal policy, its ongoing debt ceiling debates, the current debate on spending cuts in Washington and the inability of Republican lawmakers to elect a House speaker, which are all combing to make Treasuries less attractive on a near-term basis.
Supply heap
The Fed is also selling around $75 billion a month in Treasury, agency and mortgage-backed bonds back into the market as part of its 'quantitative tightening' program.
This allows the Fed to reduce the size of its $7 trillion balance sheet while lifting market interest rates that, in turn, support the higher levels of its official lending rate.
"Financial conditions have tightened significantly in recent months, and longer-term bond yields have been an important driving factor in this tightening," he added in a nod to the recent Treasury yield surge. "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."
But here's what won't happen: a collapse in Treasury bond prices.
As long as countries do business with the United States, and hedge funds need assets to offset their risks, or pension funds need to match long-term liabilities with a risk-free asset, there will always – always – be robust demand for government-backed bonds sold in the world's reserve currency.
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