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
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.
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.
This is simply a supply issue of Treasury bonds with an unprecedented deficit background. I have a chart of deficits as a % of the economy versus unemployment back to the 1970s.
What it shows is the deficit % goes up when unemployment surges (recession) and after (over a couple of years) when unemployment falls to a stable low level, the deficit % goes down and down to a consistent level of 2% of GDP. All logical.
This was all in play with the deficit % hitting over 10% in the Covid plague. When employment recovered, the budget deficits fell until mid-2022 like normal to about 2% of GDP. Then in unprecedented fashion they have ballooned to 8.6% with unemployment at a stable low.
There is a $27 trillion economy with an extra 6.6% of government deficit spending or $1.8 trillion which needs bond funding along with the competing QT bond sales.
The deficits are baked in until after the Presidential Election next November with debt ceiling agreement previously made. Of course, Congress needs to make a budget to spend what’s allowed.
In the past, the deficits were a predictable ebb and flow that didn’t overwhelm normally reliable economic and monetary indicators. Now the huge deficits distort everything, with the economy stronger than expected and longer-term interest rates surprising higher.
The US economy has consumers and businesses relatively sheltered from higher rates (for now).
So high rates are simply a function of government supply not relationships to inflation or other macro factors.
Ken, did you saw composition of Treasuty emitions ? How emition of longterm bonds increased in comparison to previous years? Do you know what are you talking about?
emissions*