Bond Yields Have Backed Up! What Next?

Bond Yields Are Backing Up!

By Chris Watling, Global Economist & Chief Market Strategist, Longview Economics

“The founder and chief investment officer of Tudor Investment said he was worried that government spending could cause a big sell-off in the bond market, spiking interest rates higher.

He said he plans to not own fixed income and will be betting against the longer-dated part of the bond market.

“Will we have a Minsky moment where all of a sudden there’s a point of recognition that what they’re talking about is fiscally impossible, financially impossible?” Jones said..”

Source: CNBC, 22^nd October 2024, https://www.cnbc.com/2024/10/22/paul-tudor-jones-says-market-reckoning-coming-after-election-on-spending-we-are-going-to-be-broke.html

US bond yields have been backing up sharply in recent weeks. On Wednesday 10 year yields closed at 4.24%, up 61bps in just over a month from their mid-September lows at 3.63% (fig 1). Much of that has been attributed to the Trump trade. That is, as the election momentum has swung towards Trump in October (see fig 6 below), cyclical trades have been outperforming (with rising bond yields one of the expressions of that cyclical trade). Trump’s policies are generally thought of (rightly) as more business friendly (than Harris’). He wants to cut regulation, lower corporation tax and ease up (probably) on banks’ capital requirements – hence as momentum swings towards him winning, the outlook for the US/global economy (theoretically) improves (& cyclical parts of the market rally).

Fig 1: US 10 year bond yields shown with key moving averages

Rising Yields -> Driven by Election Expectations, Fiscal Risks, Tariffs, Cyclical Recovery or Just Unwinding their Prior Overbought Set-up?

Bond yields could, though, also be rising for more pernicious reasons.

For example, bonds could be selling off on the back of growing concerns about the lack of fiscal discipline from either Presidential candidate (see Tudor Jones quote above); or, related to that, concerns about the need to fund a wider deficit (with higher yields required to attract buyers of the government’s debt); or alternatively investors may be concerned about the inflationary impact of Trump’s tariffs plan? All of these factors could be driving the recent move higher in yields.

Indeed, as we outlined in the (Long)View from London two weeks ago (see HERE), neither candidate (Trump nor Harris) has any plans to address the fiscal deficit. Both will most likely add to the future level of federal debt. Troublingly government indebtedness, even before any new policies are introduced, is already projected to rise significantly in the future (i.e. relative to GDP, fig 2).

As fig 2 shows under Harris, debt to GDP is projected to rise to 133% of GDP (central projection vs 125% under current law), whilst under Trump it rises to 142% of GDP (central projection). By way of comparison, Italy’s current government debt ratio is 137% of GDP (i.e. gross debt), whilst of note, it’s projected to run a primary fiscal surplus (over next few years’ forecast period).

Fig 2: Current projections of government debt to GDP shown with the impact of the Presidential candidate’s policies (%, under various scenarios)

The US in contrast, and as reported earlier this month, is running a large fiscal deficit. Last fiscal year (which ended on 30^th September 2024) that deficit was $1.833 trillion. That was +8% from FY 2023 and the 3rd largest US deficit year on record:

“The deficit for the year ended Sept. 30 was up 8%, or $138 billion, from the $1.695 trillion recorded in fiscal 2023. It was the third-largest federal deficit in U.S. history, after the pandemic relief-driven deficits of $3.132 trillion in fiscal 2020 and $2.772 trillion in fiscal 2021.”

Source: Reuters, 18^th October 2024, https://www.reuters.com/markets/us/us-budget-deficit-tops-18-trillion-fiscal-2024-third-largest-record-2024-10-18/

..…whilst over $1 trillion of that deficit was interest payments on government debt (fig 8 in appendix).

The Back-up in Government Bond Yields –> Broken Down

Interestingly, though, the back-up in government bond yields (totalling 61bps) hasn’t been all about higher inflation. It’s been reasonably evenly split between higher real bond yields (positive growth sign) and higher implied inflation. Real yields are 40bps higher (from their 17^th Sept lows); implied inflation is up 29bps (from its 10^th September lows). Added to which, implied inflation remains firmly in the midst of its normal range (fig 9 in appendix). In that sense, the extent of the move in implied inflation (and its mid-range reading) doesn’t suggest an inflation scare driven by an increasingly likely Trump victory.

More realistically, and as outlined last week, this is simply a major asset allocation switch out of bonds and into equities, that’s been going on since the August 5^th equity local lows. At that time, equities were oversold and bonds were overbought. Now, it’s the other way round (equities overbought/bonds oversold). Hence the signal from our relative medium term RSI model (for equities vs. bonds – fig 10 in appendix). Added to that, our SELL-off indicator, which signals that risk assets are toppy when it crosses +20, has also been flagging up the risk of an equity pullback (and therefore a switch into bonds) – fig 12 in appendix.

The rise in US bond yields has also been driven by improving US macro data (as well as Chinese stimulus). As fig 3 shows, yields have risen as the US Citi economic surprise index has picked up. Rising TIPS yields also correlate with reduced rate cut expectations (on the back of that better than expected macro data).

Fig 3: US 10 year bond yields vs. the US Citi economic surprise index

Added to which, the CTFC data suggests that speculators are not aggressively exposed to the LONG side of the bond futures trade – that is they have one of the lowest shares of LONG positions (as a % of open interest) in 20 years of data (i.e. on this metric, most people are already short => the pain trade is for bonds to rally) – see fig 13 in appendix.

Higher Bond Yields –> Inconsistent with the Fundamentals (at this moment in time)

Over and above those technical reasons (for buying bonds), there are also (some) fundamental reasons why yields shouldn’t stay at this high level for long.