The increasingly odd bond market

0:06Pushkin. The 10-year treasury yield just hit its highest level since 2007, and the same goes for the 30-year Treasury. We're in the middle of a historic change in U.S. government bond pricing, and it remains the biggest story in markets. Last week, bonds and stocks even moved in the same direction, down. It's not supposed to happen. It's not good for investors. Today on the show, we're going to try to figure out what's going on with the bond market. This is Unhedged, the Markets and Finance show from the Financial Times and Pushkin. I'm reporter Ethan Wu, back here in the New York studio, joined from London by Katie Martin.

0:43Katie, It was quite something to come back from the land of delicious meat pies. And the first thing I saw after getting out of the airport at JFK was a wonderful slice of half-eaten stale pizza on the floor, greeting me back to the great city of New York. That's the city you know and love. This is where you're at home with half-eaten bits of pizza on the pavement. Sorry, sidewalk, whatever it is. I didn't see any half-eaten pies in London. No, that's because we eat the pies. The pies are delicious. Yeah. England is a truly famished country. Well, Katie, we're not here to talk about pies or pizza lining New York City streets.

1:17We're talking about the huge rise in yields in the long end of the bond market. This is something we've talked about a few times in recent shows, but we got to touch on it again. There's so much to discuss here and it remains just absolutely so important for financial markets. But we should say why, right? Why does this matter? And I mentioned it a bit at the top, it's about correlation. Yeah, exactly. So the US government bond market is the single most important market in the world. And what happens there has ripple effects through to every other market on earth. Now, generally speaking, when bond yields are rising, because people are selling bonds, and the price of those bonds is falling, you got to remember those things move in opposite directions.

1:59Generally, that means people aren't so keen on holding safe assets, and they're very happy to hold stocks instead because they think they'll get higher returns out of that. So normally the two things are like a seesaw. So your bonds go down and your stocks go up and it all balances out and everybody's happy. That's not happening. What we've got at the moment is there's a bit of a chill autumnal wind sort of going through markets right now where you've got stocks in a little bit of trouble, bonds in a lot of trouble and it really feels like there's been a bit of a shift in gear in markets and people are getting a lot more nervous about kind of everything.

2:34Yeah. In the last couple of months, there's been a market shift in the way stocks and bonds are moving together. It's not pretty. I mean, this negative correlation with stocks and bonds falling is what led to some of the worst returns we've ever seen for diversified investors in 2022 when you had this big inflation scare driving stocks and bonds down at the same time. That's really, it's a tough time to be in markets because there's not an easy way to win. And it's really easy to be wrong. So early this summer, before I went on my holidays and sunned myself for a while, I was doing my normal kind of chats with fund managers and they were all telling me, right, that's it.

3:12The top is in, in yields. Central banks are done or nearly done. And with the rate rises that have been so aggressive, so harmful to bond prices over the past 18 months or so, this is a once in a generation opportunity to back up the truck and absolutely load up your portfolio with bonds because they've got the highest returns you're going to see pretty much in your professional lifetime. Just stock up on bonds while you can, specifically the bonds that are not going to default. So from your safe issuers. We'll talk about that. We'll talk about that. A few weeks later and kind of what's up with that?

3:46Like the prices are still falling, the yields are still rising. You know, the other end of the summer, it feels like something has just gone a bit pear-shaped, as other Brits say. Several reasons for this. So one of them is the oil price. Yes, it's dipped back under$90 a barrel, but it's still pretty elevated. And the only reason it's fallen is because people are starting to think these yields are now getting high enough. Borrowing costs are getting high enough that maybe that recession that we've all been warning about for 18 months really is about to turn up any day now. The other is this idea that the US Federal Reserve is not done.

4:22Like you think the top is in in rates. What if it's not? What if they've still got more to do? we've had a couple of Fed governors over the past couple of days saying, look, it might be that we need to do more. It might be that energy prices undo the progress that we've made on bringing inflation down. And you also had the Fed chairman, Jay Powell. He was on a tour of small business owners in Pennsylvania the other day. And it sounds like he got a right earful from business owners saying, I can't get the labor. I can't get the parts. I can't get the stuff. Prices are going up. desperately saying, please do more about this inflation that's hurting our business.

5:00So the pressure is still massively on the Fed, even though inflation has come down, to just keep going, keep going. And that just means that yields just keep on shoving higher. When we thought it was done, we are not done. No, you laid out several key reasons why the yield's going up, but let's break it down. I think there are four reasons, three on the demand side and one on the supply side that are just continuing to drive long-dated yields higher and higher and higher. Let's start with the demand side. This includes a couple of things that you just referenced, Katie. One is the Fed's rate increases.

5:33Are they done? That's number one. Number two is inflation risk. Has it gone away yet? And number three, and this one is a little maybe more nebulous, is the government going to default at some point in the future, right? So, I mean, let's take these one by one, just starting with the Fed. You just talked about it. There's been a lot of recent Fed chitter chatter about, are we really done? There looks like some persistent elements of this inflation. We might need another rate increase. We've mentioned on the show, JP Morgan, CEO, Jamie Dimon thinks rates are going to 7%. That may or may not be the case.

6:04World's greatest bond trader. You heard it here first. And that requires a real forward thinking. But if you just look at what's ahead of us, it's very possible that in December, perhaps at the Fed meeting, they do another quarter percentage point rate increase. That's totally possible. And then there's the question of how long does it stay, right? Markets care a lot about the timing of when rate cuts happen. And it matters if rate cuts happen in March versus in December versus in 2025. I mean, those are very different worlds in financial markets. And so I think as the additional rate increase becomes something that's increasingly a live possibility and the extent of higher for longer, how long those high rates are going to stay, that's pushed yields up.

6:45Yeah. That's a really toxic combination. So that's rate increases are pretty straightforward. But next is inflation risk. And this is just, if you're buying a 10-year treasury, for example, you care a lot about what the average inflation rate is going to be over the next 10 years. That seems increasingly in question, right? And there's multiple parts of it. There's, you know, is inflation going to come down quickly, or is it going to come down slowly? Is it going to stay elevated? Are we talking about a permanent 3 % inflation world, right? These are all, I would say, perfectly open questions.

7:16And I think the main thing, Katie, is we all have learned from the past two years of experience that we do not understand inflation. And if you don't understand inflation, you're going to require a little bit more payment on that treasury yield side to compensate for the risk. Yeah, you demand higher payment, you know, higher rates of return. Inflation, it's basically kryptonite for bonds. Like bonds just can't stand the stuff because you get a fixed rate of coupons of interest payments that come through from buying these bonds. But if inflation rushes higher at a faster pace than the rate you're getting on your coupon, then you're effectively getting less and less and less money every year.

7:51So it's just a bad combo. It's just exactly the opposite of what bond investors like to see. Yeah. And I think if you're a bond investor, I mean, it must be just incredibly humbling to have lived through the past couple of years. And just, I remember three, four, five times where people said, well, this is the peak. Well, oh, this is the peak. Well, this is the peak, right? And oh, it's coming down, it's coming down, it's coming down. I can't think of a single person that called both the ascent and the descent correctly. I can't think of one person. I'm quite sure they will email you if they did.

8:21But we want to see receipts here, listeners. Yeah. If you have timestamped receipts of you calling this inflation cycle perfectly, please let me know, ethan.wu, wu.ft.com. But listen, it's hard. And I think Jay Powell nodded to this the other day. He said, we're still shaking off the effects of COVID. And I think that's absolutely right. There's so many moving parts in the economy. There are sector shifts. There are still some supply disruptions. There's this incredibly strong consumer in a way that people didn't expect. It's too many things to put into a traditional model of the economy. It's just way too complex.

8:54Yeah, for sure. So that's rate increases and inflation risk. And lastly, and we'll just touch on this briefly, there are some people that are worrying about government funding risk, right? Like what's the chance of default that would cause a missed payment on a treasury bond. This feels almost like an old hat now, but a couple of months ago, we had all this default drama and the debt ceiling and are they going to reach a last minute deal and so on and so forth. And one of the credit rating agencies downgraded US government debt, which is not what you want to see. I don't think a default is going to happen.

9:23But the big thing that people are talking about is the other D word, which is very scary to bond markets, which is deficits. People used to talk about fiscal deficits as in a gap between the amount of money governments have available to spend and the amount that they have to borrow to meet their spending requirements you know if they're basically in hock to the bond market that's called a deficit deficits are suddenly back and and this used to be something that obsessed markets for years and years and years and then we forgot all about it because interest rates were so low because who cares if you need to borrow eleventy squillion dollars you can borrow them for basically free because the base rate is practically zero.

9:59So who cares? Load up. Now, the kind of benchmark borrowing rate is significantly higher than it was before. And all of a sudden, investors are starting to talk about deficits again. How can governments keep on issuing? How can they keep up all of their spending promises? How can they rely on someone being on the other side of that to buy these bonds off them? And if you can't rely on someone being on the other side of you to buy those bonds, then you're going to have to pay a higher and higher rate to lure those investors in. Then you've got a problem. because then all of a sudden whenever you're servicing that debt, so paying out your regular interest payments or whatever it is or paying back the bonds, that is much more expensive and all of a sudden you've got something that smells a lot more like a fiscal problem.

10:41This is creeping into conversations all of a sudden where it's laying dormant for years and years. Only this morning I was at an event for First Eagle Investments. They were talking about precisely this issue and they were saying one way that they like to mitigate against that is to look at buying gold as a hedge. I can't remember the last time someone made the case for buying gold to me. And I would note, listeners, that gold is down pretty significantly over the past few weeks. But, you know, the fact that people are starting to talk about this again, Europe has got a bit of a problem with meeting its fiscal targets.

11:14Italy is saying it wants to borrow more than the market had previously anticipated. You've got suddenly the idea of bond vigilantes being back. The market's saying, no, no, no, we're going to enforce some fiscal discipline on you, actually governments. And if you want us to fund your spending programs, you're going to have to pay up. At least one US senator has been into buying gold. But anyway, that's not the point. You've brought us, Katie, from the demand side, rate increases, inflation, government funding risk, to the supply side, which is all about the deficit. The treasury market, as Alexandra Skaggs put it over at Alphaville, is the original public-private partnership.

11:46The government relies on private investors to absorb the borrowing through the issuance of treasury bonds. The problem is if you need to issue a crap load of treasury bonds - Is that the technical term? Do you prefer boatload? Shed load. Yeah, that's the one. Yeah, shed load. I think you are the first person I've ever heard use the word shed load. Anyway, so if you need to issue a shed load of treasury bonds as the government, the government's going to have to pay up. You need to keep attracting investors. And yeah, maybe some amount of investors will accept a certain yield on your treasury bonds.

12:22But if you need to issue double that, right, or 1.5 times that or whatever, you have to keep attracting the marginal investor. And that marginal investor who maybe otherwise wouldn't buy the bond is going to command a higher and higher interest rate. Exactly. And bear in mind, you don't have the Fed doing quantitative easing anymore. You don't have it deliberately buying bonds to push down bond yields. So that's one marginal buyer that's out of the picture. There are some overseas central banks that might look at the experience that Russia had where it had its assets frozen and, you know, think, well, I don't particularly want to take on dollars just in case I annoy the US in some geopolitical sense, and then I can't get my dollars put into work again.

13:01There's lots of these little marginal things that just suggest that there's going to be weaker demand out there and more supply out there. And, you know, it doesn't take a genius to figure out that the US might need to pay up more to get these bonds away. Yeah, I'm really glad you brought that up. I mean, there are all these things shifting in the world about the role of the US dollar and US debt securities, you have things like global central bank reserve managers, people that run basically the bank account of the government, are diversifying a little bit away from - A tiny tiny bit like glacial pace.

13:36But again, we're talking about marginal differences here. Yeah, yeah. But I think the marginal change matters because it determines what the marginal rate the treasury has to issue at a bond auction. And there's things like in Japan, interest rates are maybe slowly creeping up. And so that makes Japanese bonds a little bit more attractive for Japanese investors. And so maybe they're kind of exiting the market a little bit. All these moving parts, right? But like you said, Katie, the long and the short of it is that treasury department going to have to pay a little bit more interest, maybe a lot more interest to issue treasury bonds.

14:07And the other long and short of it, and we're going to come on to our long short listeners, is that people who are supposed to understand how bond markets work, get it wrong again. So be cautious around people who express confidence around how this is going to pan out because nobody knows. That's absolutely right. Well, I think you set us up with the perfect transition to long short. So we'll be back with that in a minute.

14:33Welcome back. This is long short, that part of the show where we go long a thing we love, short a thing we hate. Today, listeners, this is the crow eating segment of the show where I will apologize for my truly dismal long on the crypto sort of kind of hedge fund, Three Arrows Capital. On one of the earliest unhedged episodes, I said I was long the Three Arrows Capital guys because they were never going to get arrested. They were going to party in Bali till the day they died. I was wrong. You were wrong. I told you you were wrong at the time, to be absolutely fair. Listen, I thought these guys are relatively savvy crypto traders, And I wrongly assumed that they're savvy with crypto trading would lead to some savvy in terms of avoiding arrest, but apparently not.

15:16Suzu, founder of Three Arrows Capital, was arrested in Singapore the other day. And listeners, I will eat an entire crow or maybe five. How many crows do I need to eat? You need to eat a crypto crow. The worst type of crow. Am I long that or am I short that? I don't even know. I guess I'm short my ability to make longs that pan out. Short yourself and your short three arrows. So I will be long something. I will be long Japanese yen at this point. It's weak. It's all sorts of weak. It's terribly weak. The dollar is just, you know, blasting a hole out the side of the yen. Exactly because all this stuff we've just been talking about, right, with yields in the US pushing higher and higher and higher.

15:57That pushes dollar yen significantly higher, which means that the yen is super weak at the moment. We are now very much in intervention territory. so the authorities in Japan have made noises about not being comfortable with the yen being this week they like a bit of yen weakness but come on like dollar yen at 150 is right really pushing it I would not be at all surprised to see some sort of intervention in the coming days the last time we saw that was in September they intervened to support the yen which is very unusual for Japan they hadn't done that since 1998 I would not be at all shocked to see that happen again sometime soon I remember people saying like well how long can they maintain this It's like, you know, the dam's going to break at some point.

16:37No, they can kind of maintain it as long as they feel it makes sense. If they're acting on their own, if they're just intervening on their own, then it won't work durably. But it will be a pretty sizable speed bump. Yeah, they can slow the decline, but they can't stop it. I think that's right. All right, Katie, it's good to be back with our normal New York-London setup. And listeners, catch you again on Thursday for another episode of Unhedged. We'll see you then. Unhedged is produced by Jake Harper and edited by Brian Erstad. Our executive producer is Jacob Goldstein. We had additional help from Topher Forges.

17:11Cheryl Brumley is the FT's global head of audio. Special thanks to Laura Clark, Alistair Mackey, Jacob Weisberg, and Jess Trulia. FT Premium subscribers can get the Unhedged newsletter for free. A 30-day free trial is available to everyone else. Just go to ft.com slash unhedged offer. I'm Ethan Wu. Thanks for listening.

18:00London time. We're going to be discussing macro trends, how they're impacting the rally, what factors will determine if this will continue. Speakers include senior executives from Pictet Japan, Bailey Gifford, and Neuberger Berman. You can register for free on FT Live's website or by visiting japanesestockmarketrevival.live.ft.com. The link will be in the show notes.