The big moves in fixed income - getting to equilibrium faster

 

Call it the "Great Bond Freak-out," as long-term yields have consistently moved higher, as measured by 3-day changes. The direction has been clearly upward, and the moves have been the largest since the Liberation Day debacle. The market has repriced bond risk quickly. Inflation expectations, while seemingly well managed, are above the 2% target. Real rates have risen on higher expected growth and stronger demand for AI financing. Monetary policy is moving to a hawkish stance, which places further pressure on the front end. 

The sudden repricing of bond risk should attract attention, but it does not imply bond market irrationality. Perhaps the irrationality was with the false valuations prior to this move higher.

The short-term market is telling us rates will be higher

A good indicator of rate direction is the spread between 3-month Treasury bills and 1-year rates versus the EFFR. Market rates for slightly longer maturities show that the market is willing to clear at higher rates, and implied forward rates will, by definition, be higher. The switch from falling to rising rates occurred earlier this year, with the 1-year vs. EFFR spread rising sharply in the last month. Nothing suggests rates are headed lower.

Bonds at fair value - perhaps opportunity

We can look at real yields and say that real rates may be high, but there may be a view that real potential GDP is likely to fall and the natural rate of interest is lower.  If we assume growth will be higher, and the natural rate is closer to a longer-term average, we can say real rates have risen sharply, but their current level is not excessive. 

If we think nominal rates may be near fair value, we have to ask what the impact is of a 100 bps increase versus a 100 bps decrease. In that case, the risk-to-reward suggests that bonds may be attractive. If you assume the probabilities are equal, you may want to consider buying bonds. 

 

The demand for credit - both public and private

 

Most investors are concerned about the size of government debt. They should be. Deficits are out of control, with interest pushing debt-to-GDP higher as the cost of past excesses. Primary debt remains high with no controls in sight, yet the problem is broader. 

There is a strong demand for private capital given the strong increases in global capex. The private sector is competing with public markets for savings, and the cost of capital is increasing. Technology is showing strong capex, but the commodity sector is also demanding capital. Beyond energy, there is a strong need for many metals, which is finally leading to more capex after the decline in the aftermath of the commodity supercycle in 2008.

The competition for capital is real, but it is not clear that public markets are a better credit. 

What is the fixed income market telling us?

 

Fed Chairman Warsh stated that he will not provide forward guidance. The fixed income markets should do their own signalling. The combined weights of bond market participants should tell others what they are thinking. The market is speaking, and it is telling us that rates are going higher. The spread between the 2-year Treasury market and the EFFR is widening, suggesting rates will rise for a longer period. The market is expecting the Fed to raise rates to fight inflation. There are no Fed rate cuts expected as desired by the President. 

Nevertheless, we have to place the current rate increases in context. It is a return to normal after the QE and ZIRP era. That does not mean the economy will not feel the pain. The cost of capital is ,rising, which means projects will be rejected because they will not be financially attractive. 

When the extraordinary continues for too long, it becomes normal, and a return to the true normal becomes abnormal.

Bond markets - is this just a return to normal

 

There is consternation in the bond markets that may be unwarranted. Rates are higher, and the sell-off has been strong, but we are returning to the normality seen before the GFC. Was the post-GFC period normal, or is the current environment, with a positive real rate, an inflation premium, and a term premium, the norm? 

I would argue that the current environment is a return to normality, and the low interest rates during the QE period were abnormal. The Fed and the Us Treasury cannot be in a continual mode of amping up the economy. There has to be a focus on inflation and controlling credit excesses. Of course, there is a threat of recession, and people will be in need, but the labor market is close to full employment, and inflation is well above target. 

Should we expect lower bond yields, or is the market just reflecting reality? 

How bad are the bond market returns?

 

Bonds are a bad bet, or have been a bad bet. In fact, the current period has been the worst in the longest history available. It is worse than the period of high inflation in the 1970's, worse than the Civil War. 

However, there is hope. As rates move higher, current yields rise, which offsets some of the capital loss. Coupons provide a cushion for further yield increases. Total returns can improve quickly if overall yields are higher.

Who is the marginal. bond buyer?

 

To price assets, you ned to know who will be the marginal buyer who will clear the market. How sensitive is the buyer to value or economic shocks? For the longest period in the US, the Fed was the marginal buyer through QE. QT was tried, but there always seems to be a hesitancy that selling would stop or slow down if rates rose too quickly. Now, the world has changed. The marginal buyers are private investors. Those private investors may either be domestic or foreign. Again, the issue is whether the marginal buyer needs to hold safe assets regardless of valuation or whether these buyers focus on valuation. I place less emphasis on Treasury arbitrage and basis traders, which is a different problem. If the perception is that bonds are expensive, or, more importantly, that rates are trending higher, yields will clearly be higher. 

Nominal yield will fall only if inflation expectations fall, term premiums fall because risk is perceived as lower, and real rates move lower because growth slows. Pension funds and insurance accounts will drive the US bond market. These buyers do not have to be vigilantes; they can just price-sensitive investors.

Saying good-bye to Treasury as a safe asset

Treasuries have been a safe asset, but it’s unclear whether they still are. A safe asset means investors will pay a premium to hold it, so a convenience yield exists between it and the next safest asset. Treasuries will trade at a lower yield than AAA-rated bonds. This convenience yield is time-varying. It will change with the business cycle and market fragility. A crisis or recession will raise convenience yields. Similarly, if safe-asset supply increases relative to demand, the convenience yield will decline. Ultimately, perceptions of safety matter. Treasuries are safe because they are viewed as safe relative to other alternatives. The structure and liquidity of the safe asset affect this perception.

Unfortunately, convenience yields have collapsed and are showing no safety premium. This is consistent with a positive stock-bond correlation. Safety from Treasuries relative to the risky asset is limited, given they are moving in the same direction. This is more than a correlation story, so investors should take note of the fall in convenience yield.

 

So what about bond risk - MOVE index has moved lower

A news report creates market buzz, but it is important to look at the numbers: the MOVE index for bond market volatility is still in a longer-term downtrend and is off the high from earlier in the year. The buyback announcements have caught the bond market's attention, but that has not translated into higher volatility. 

Our second graph shows the percentile level over the last ten years as a time series. We are significantly off the high of the high-inflation period. Rates have increased, but this has not translated into market highs in volatility. 

 

More on Treasury buyback operations

 

hat tip Kevin Coldiron - the ideas lab for graphic 

The Treasury buyback program has received considerable attention, but some key foundational information is missing. The current buyback program has been in place since 2024 and can be broken into two parts: the cash management portion is conducted when seasonal tax receipts come due or when the TGA has excess cash to time debt retirement with cash available, and liquidity support buybacks that are tied to specific bonds to ensure that the Treasuries outstanding have added liquidity. We will see both cash management operations and liquidity support increasing, so there will be a larger active player in the bond market.

The amount of debt does not change. Additional bill issuance is used to retire old, less-liquid coupon debt in equivalent size. Yes, there may be more T-bills outstanding to stabilize trading in less-liquid coupons. It can be viewed as refinancing/composition operations. In some sense, buybacks are like the Operation Twist (2011-12) from the Fed because the supply of bills will increase while supply out the curve will decline.

The Fed has stopped its balance sheet runoff but still buys bills to provide ample reserves. The Treasury will issue more bills, so the Fed will buy some of those bills, which will ensure reserves do not change. In the short run, the Treasury may issue more bills, but it can also issue more on-the-run Treasuries to fund buybacks when it makes regular issuances.

Whether you like it or not, the Fed and Treasury will coordinate more. To some degree, these two will coordinate their actions. 

Bond Vigilantes are Global

 

If the bond vigilantes are back, it is not just in the US. Rates in other G7 countries have been rising, and the US is not the only one. Global bond markets are repricing risk, and there seems to be a common concern about government budget deficits. The problem is that government deficits are high and generally getting higher. The exception is Japan. The problem is that deficits continue to rise because interest rates are also rising, so financing costs strongly drag on any improvement in the budget deficit.

One key reason the US wants to lower interest rates amid persistent inflation is that rising financing costs limit room for further spending increases without larger deficits or higher taxes.  

The bond investors are fully aware of the budget math and they want to be compensated for the added financing risk. 

Druckenmiller - Vigilante or truth-sayer?

I have spent five decades trading on a simple premise: Markets aggregate information no committee possesses, and prices are how that information reaches decision-makers. The long-term Treasury yield is the most important price in the world. It is also the only fiscal disciplinarian the U.S. has left. 

Every basis point of artificial yield suppression is a subsidy to procrastination. Suppressed long rates sugarcoat the interest-cost projections, shrink the apparent urgency, and let incumbents assure voters the debt is someone else’s problem. 

Stan Druckenmiller WSJ opinion piece 

Stan Druckenmiller had a few choice words for Treasury Secretary Bessent's changing buyback plan. The objective of the Bessent plan is not just to provide liquidity to the long end of the yield curve, but to try to bend long-term yields back to lower levels through buybacks that support bond prices. This is an attempt to stop the flood with a bucket. The fundamental problem is the size of government debt, and there is no solution. 

The first quote is spoken like any true trend-followers: market prices aggregate and disseminate information. This is foundational to any market signaling, 

The second quote focuses on the problem: the government just wants to lower the cost of the problem.

Treasury buybacks - what does it mean?

 

Treasury Secretary Bessent announced a Treasury buyback program, an increase in an existing program, amid much market discussion about its objectives and what it means. Investors should note that this does not change the size of the deficit or the Treasuries outstanding. It may change the debt’s composition and will affect the spread between on-the-run and off-the-run bonds. For the Treasury market to function well, off-the-run bonds need strong liquidity, and this should be the main focus of this program.

We are concerned with the plumbing of the Treasury market. Primary dealer capital is constrained under current bank regulation, so dealer capital is out of balance relative to trading and outstanding debt. Dealers must maintain high leverage, and if capital is insufficient, their ability to maintain orderly markets is compromised. 

The unstated and overlooked issue is the potential problems in the plumbing of the Treasury market. Actions are being taken to constrain the potential for a liquidity crisis. The chief bond salesman - the Treasury secretary - is not going to talk about this issue.

Treasury buybacks - A history

The Treasury announced an increase in its Treasury buyback program from $2 to $4 billion per operation. This is not the first time buybacks have been used to support the Treasury market, yet this action suggests plumbing problems in the Treasury market. Past buybacks have focused on ensuring more Treasury market liquidity. We expect the same for this program, but it also means the Treasury will be an active liquidity provider in the Treasury market. 

Hedge funds and Treasuries - An unholy alliance

 

This may seem obvious, but hedge funds dominate a significant portion of Treasury trading. Their exposure exceeds that of mutual funds, and their behavior strongly affects market direction. These are not the same bond vigilantes of long ago, but a breed of arbitrageurs and directional traders ready to go long or short based on small market deviations. They are both liquidity takers and makers. Their turnover is significant, and they use substantial financing.

You have to ask: what happens if they change their strategies, or if losses elsewhere in their portfolio lead to deleveraging? Treasury prices are unlikely to rise, and liquidity will decline. Regulators have little to do. Do you want hedge funds to leave the market? Data from Decomposing Hedge Funds’ U.S. Treasury Exposures.

TIPS yields continue to move higher

 

It is not just nominal yields that are moving higher. Real yields have also been on a steep ascent, with levels at the highest in ten years. In fact, to get to these real yields, investors will have to look at data prior to the GFC. We are in a strong situation where real yields are telling investors that we have tight monetary conditions, yet inflation and nominal yields suggest that concerns about inflation are real. This places the Fed in a difficult policy environment and clearly is a reason for FOMC voting disagreement. 

Yields at levets not seen in a decade

 

Since the pandemic, 10- and 30-year Treasury yields have been on a steady march higher. We have seen continued inflation above target, continued budget deficits, the shock of pandemic QE, and no strong policy moves to stop the ascent. We are now seeing rates that will take us back up to pre-GFC levels. Could this be considered normalization of rates? This is hard to argue when you look at the combination of inflation and budget deficits. We are moving into a new period of rate behavior, and levels are unlikely to move back to the 3 percent range unless we have a large economic slowdown.  

Treasury convenience yield and inflation

 

The convenience yield associated with Treasury securities is dynamic, meaning the price of safety associated with this safe asset is constantly changing with the macro environment. This important paper, "Inflation and Treasury Convenience,” on the macro dynamics of the convenience yield finds that inflationary supply shocks raise the opportunity cost of holding money and money-like assets, increasing convenience yields. Exogenous liquidity demand shocks will also elevate convenience but depress consumption and inflation. Given the difference between supply and demand shocks, there will be a weaker convenience-inflation link in the post-2000 period, which saw more liquidity demand shocks.  

This shows that convenience yield will be associated with macro dynamics and not just the demand for safety. My view is that this work makes it more difficult to discuss when there is a change in safety for Treasury assets. Yes, we can say it will be linked with macro dynamics, but ultimately most are interested in the price of safety based on some form of risk.

JGB rates starting to matter to the rest of the world

Japanese 10-year JGB yields are now 2.34, the highest this century. An end to loose monetary policy, continued loose fiscal policy with the expectation of a tax cut, the "Takaichi Trade", and persistent inflation that is currently at 2.9% means that there is a strong reason to see yields move even higher. The rising JGB rate is having an impact worldwide as money starts to flow back to Japan. Now, it is hard to say this is a complete reversal when real rates are still negative, but the global financial landscape is changing, putting pressure on Treasuries and rates in other countries.