What’s spooking the bond market, and why it matters to equities

What’s bothering the bond market? The 10-year Treasury yield (blue line) has shot up to levels last seen just before the GFC. The surge in yields has occurred just as investors are seeing better news on inflation. At the same time, core PCE (red line) has been falling. Shouldn’t that be good news for the trajectory of monetary policy? Why are yields rising?



Good news on inflation and employment

The rise in yields is occurring against a backdrop of good news on inflation and employment. Core PCE, which is the Fed’s preferred inflation metric, has been running at a monthly annualized rate of below 3% for the last three months. Core CPI has been similarly tame. The latest reading shows core CPI at a monthly annualized rate of 3.4% and core PCE at 1.8%. The key difference between the two indicators is that CPI measures a price basket paid by the consumer while PCE measures a basket received by businesses.


Despite the strong headlines from the JOLTS and nonfarm payroll report, the jobs market also shows welcome signs of cooling, which is welcome news for the Fed. The market was rattled last week by the surprise uptick in the headline job openings figure in the August JOLTS report, but internals are consistent with a slowing jobs market. Historically, both temp jobs (blue line) and the quits/layoffs ratio (red line) have led nonfarm payroll employment (black line). Quits/layoffs from the JOLTS report shows an albeit noisy cooling trend.


The strength in the nonfarm payroll report looks anomalous. While the establish report beat expectations with a gain of 336,000 jobs, the more volatile household survey showed only a gain of 86,000. However, an outsized 73,000 of the growth came from government jobs and 70,000 from education and health care. Average hourly earnings also missed expectations, indicating tame wage growth. Monthly annualized average hourly earnings have been rising at 2.5% for two consecutive months, which is another indication of disinflation.


In addition, Bloomberg Economics tracked WARN notices, which large firms have to file if they plan to lay off more than 50 people, and found that companies in the sun belt and rust belt are planning mass layoffs.


These data points should be good news for interest rates. Indeed, Fed Funds expectations have steadied to no more rate hikes, followed by rate cuts that begin in mid-2024. In addition, San Francisco Fed President Mary Daly stated that the recent rise in bond yields is roughly equivalent to one rate hike, which reduces the odds of more hikes should current conditions persist.



A rising term premium

In light of the good news on inflation and employment, why are bond yields rising? The answer lies in a rising term premium.


For the uninitiated, the term premium is what the market demands for holding a fixed income instrument for longer compared to a short-dated instrument. The term premium for a 10-year zero-coupon Treasury has risen by about 70 basis points since May. The related inflation-index yield, or TIPS yield, surged even more and stands at levels last seen during the GFC.



Here’s why this matters for equity investors. The S&P 500 has shown a close correlation to TIPS prices, but they began to diverge last September and diverged even further last April. Arguably, the carnage in the bond market should be depressing the S&P 500 down to the 3000–3200 level.



The bull and bear cases

What accounts for the surge in term premium and how should investors position themselves?
The increase in term premium can be attributable to worries over the ballooning fiscal deficit. This raises the question of whether the market would suffer indigestion in absorbing the flood of new Treasury supply.


One of the main buyers of Treasury issues is foreign central banks, and the biggest holders of Treasury paper is China and Japan. Recent data shows that China has been selling Treasuries (red line) and pushing up rates.


Brad Setser at the Council on Foreign Relation disagrees with the China is selling narrative.
Strange as it may seem, the best evidence available suggests that the dollar share in China’s reserves has been broadly stable since 2015 (if not a bit before). If a simple adjustment is made for Treasuries held by offshore custodians like Belgium’s Euroclear, China’s reported holdings of U.S. assets look to be basically stable at between $1.8 and $1.9 trillion. After netting out China’s substantial holdings of U.S. equities, China’s holdings of U.S. bonds, after adjusting for China’s suspected Euroclear custodial account, have consistently been around 50 percent of China’s reported reserves. Nothing all that surprising.
Notwithstanding Setser’s analysis, I agree. While the China selling story may make sense from a geopolitical viewpoint, as Sino-American relations have deteriorated, it doesn’t from a currency level viewpoint. If China were to undertake a substantial sale of Treasury and Agency paper, where would the money go? If the funds were to be re-invested into another country’s paper, it would show up as USD weakness and strength in the new recipient currency. So far, USD strength has been relentless and I have seen little strength in either the yuan or in other currencies.


Another concern is the shifts in BoJ policy to step away from yield curve control and allow the 10-year JGB yield to rise. Japan has been a source of global liquidity for decades, and this shift in BoJ policy could increase demand for JGBs at the expense of the demand for Treasuries and other foreign paper by Japanese savers. As the accompanying chart shows, the Yen repatriation scenario has not occurred. Even as the 10-year JGB yield rose, the 10-year Treasury yield rose more. The Treasury-JGB spread has increased, which encourages Japanese savers to invest in USD paper. And that trend is evident in the rising USDJPY currency rate.




Credit event ahead?

So where does that leave us?


On one hand, the bears could argue that the term premium is only normalizing to historical levels after a period of suppression and the 10-year yield could end up at as much as 5%. The rapid increase in bond yields raises the risk of a credit event. U.S. Bank losses on held-to-maturity assets have soared to an all-time high of $400 Billion. Such extreme losses have the potential to spark a disorderly margin call unwind in the manner of the gilt market crisis of 2022.



The bulls will argue that the markets should be able to adjust to a normalization in the term premium in a benign manner. The last time real yields rose this rapidly was the Taper Tantrum of 2013. We are at or near the point of maximum pain.



One surprising development is the lack of anxiety in the high yield market. High yield spreads have barely budged, indicating a lack of anxiety.



From a technical perspective, the 30-year Treasury yield, whose peaks have led the Fed Funds rate, is testing a key resistance level that goes back to the GFC. Keep in mind Bob Farrell’s Rule #4: “Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways”.



The rise in bond yields has occurred against market expectations that the Fed will not hike rates. If inflation continues to fall, real rates will rise and financial conditions may become too restrictive and cause the Fed to ease nominal rates, which would be a surprise for the consensus “higher for longer” narrative. Any hints of a turn in Fed policy would set off a FOMO scramble to buy bonds.


Jason Goepfert of SentimenTrader observed that news articles mentioning “relentless” and the bond market have spiked to the second highest level in over eight years, indicating excessively bearish bond sentiment, which is contrarian bullish.



There is also good news for equity investors. The S&P 500 is experiencing continued upgrades in forward 12-month EPS expectations. FactSet reported that a record number of companies have issued Q3 earnings guidance, indicating managements’ greater certainty about their operating environment. I am cautiously optimistic for Q3 earnings reporting season.



In conclusion, the financial markets have taken a risk-off tone as bond yields rose. The increase in yields is occurring against a backdrop of better news on inflation and employment, and expectations that the Fed has seen the last of its rate hikes. If the nominal Fed Funds rate stays steady and inflation falls, this will induce higher real rates, excessively tight monetary conditions and eventually a pivot toward easing. I believe the market is at or near the point of maximum pain and investors should be prepared for a FOMO scramble for bonds and risky assets.
The coming week could be a pivotal one for the Treasury market and the trajectory of risk appetite. The bond market is closed Monday for the Columbus Day holiday, though the stock market will be open. It will be followed by $103 billion in Treasury issuance and the CPI and PPI report, along with the release of FOMC minutes.