Why the bond market matters now

0:06Pushkin. Listeners, we talk a lot about the stock market. It's big, it's exciting, there's AI trade. We'll come back to it, probably on Thursday, actually. But there's another market that's been capturing a lot more attention recently, and that's the bond market. The bond market's not only bigger than the stock market, but it tells us more about the U.S. economy. If the stock market is like your drunk uncle, the bond market's like your sober, bookish aunt who spends a lot of time studying. Today, we're talking about the U.S. bond market and the message it's sending right now about the U.S. economy.

0:42This is Unhedged, the markets and finance show from the Financial Times and Pushkin. I am reporter Ethan Wu here in the New York studio, joined as ever on Tuesdays by bond market maestro, Katie Martin. Maestro, is it now? Hey, Ethan, how are you doing? You conduct The Bond Market Follows. Katie, I don't know if you caught, just as a sidebar before we get into the discussion, I don't know if you caught the episode I did with Rob Armstrong the other week on commercial real estate, but do you know what he said to me? I called him a grizzled veteran and he called me broke. I called him old and he called me poor.

1:14Can you believe that? Yes, I can. He's a bad person. I've warned you about him. I will not be calling him a grizzled veteran again. But, you know, grizzled veteran status does help in discussing the bond market. You know, this is one for the old heads out there. The cool heads. Bonds have always been cool. And they're cool again. So cool. Bonds are back to the point where people who work in bonds for a living, who people in equities have been laughing at for years because they buy these rubbish little electronic bits of paper that don't yield them anything, are now saying, oh, nice, nice little market you've got over there.

1:51How do I buy some of these bonds that you've got? And, you know, I was chatting the other day to a chap called Anders Person, who is the head of fixed income at Nuveen, huge, huge asset manager. And he said his colleagues used to jokingly call him the head of no income instead of the head of fixed income. And they're not laughing now. They're saying, hey, have a look at that. You can lock in like a 5 % yield on a two year U.S. Treasury. I'll have a bit of that. So, yeah, bonds are suddenly drawing a crowd that was definitely not there before. It can't be overstated that Wall Street runs on bullying.

2:26Yes. Bullying and banter. It's the fundamental force making the whole street work. Katie, so just the proposition for yields, right, why they're attractive, it just comes down to the fact that you can earn a nice little coupon, a nice little interest rate on it, taking pretty much no risk at all if you want to hold U.S. treasuries. Or if you want to take on a little bit more risk, you can buy yourself some investment grade, buy yourself some high yield. I really thought you were going to say guilt there. UK government boss. See, that's a risk that I don't think anybody should be taking. There's a very high probability of default.

3:02You're so mean about us, Brits. But yeah, for years and years, right after the crisis of 08, Tina was in charge of markets, right? There is no alternative. Tina. And now all of a sudden there is an alternative because you don't have to necessarily buy equities or super, super risky types of debt because you can just buy bonds. Called me old fashioned. So like months ago, I tried to make the new acronym to replace Tina to be bonds. What was it? Oh, hang on. It was buying ordinary notes and debt securities. That was it, bonds. And I tried to make that stick as a thing. It did not stick. My colleague, Robin Wigglesworth, pointed out that it should in fact be bone ads to include the and.

3:48And that, thankfully, also did not stick. So we don't have an acronym to replace Tina. If any of our SAGE listeners have any good ideas, please email Ethan directly. Please email me. Email me personally. Don't CC Katie. Give me the ideas. I will be the broker. But anyway, Katie, so that's the big picture value proposition, right? Bonds are back. Coupons reasonable. You can take different levels of risk. And I think that can't be separated from the fact that equities do look relatively risky right now, all things considered. But that's not to say that there aren't risks in bonds. And I think you can kind of separate the risks into the short-term risks and the long-term risks.

4:31And we've had recent demonstrations of both types in the bond market just in the past couple of weeks. I mean, to start with the short-term risks, Katie, I mean, this central bank rate increase cycle, a lot of people thought it was over. It's not over. Yeah. So you have to think about why yields are higher, right? Which is that we live in this new, more inflationary environment. And pretty much ever since the Fed started raising interest rates, investors have been trying to talk themselves into this mindset where they're going to reverse it, right? There's going to be a pivot. They're going to start cutting these rates.

5:05So what this reminds me of is the film Mean Girls from 2004. Had you been born by then? Probably. Yes, I was born. My girlfriend in middle school forced me to watch this movie. Well, you all know the scene from it where there's a character who's trying to make the word fetch a synonym for cool. And one of the characters says to her, stop trying to make fetch happen. There's a similar thing going on now, right? It's like, stop trying to make the pivot happen. The pivot is not going to happen. The fed is not your friend. It is not going to cut rates just because you want it to and just because you think.

5:41Jerome stopped trying to make the pivot happen. Not sure that works. He never has been trying to make it happen. But the markets need to accept that they're not going to make the pivot happen quickly. Yes, the market is pricing in some rate cuts at some point further down the chain from the US. But the idea that they're going to come this year, for example, is very much getting pushed back because the US economy is just too hot. It can't do it. But now we've got a situation where the US economy is so hot that the risk that inflation stays higher for longer is so pronounced. So that means that if you are one of these many people that's got into bonds because you think they're cool again, brackets, they were always cool.

6:20But if you've got into bonds in the last few months, I'm really regretting bringing that up, then you've lost money on paper, right? If you're checking on where your bonds are, just like you would check on how your stocks are performing, then you're like, hang on, these things are worth less than I bought them for now. Those nice people at the FT told me that I was locking in a certain return. And you are as long as you hold them until the bitter end, right? This is exactly where I wanted to go, which is the yields you see if you Google what the 10-year yield is or the two-year yield or whatever.

6:55That only applies if you buy the bond and then never touch it again, right? If you sell it, you can totally incur a loss because these things trade on a secondary market. The price goes up and down. Yeah. You know, that's the point. The whole point is that last year was a big exception because bonds and equities fell in tandem. The whole point is that bonds are supposed to rise when your equities are doing really badly and they're supposed to fall when your equities are doing really well. So they're actually doing what they're supposed to do right now, which is weakening while equities are pushing higher.

7:27you can argue about why equities are pushing higher, whether it's sustainable, all that stuff. Doesn't matter. The numbers are the numbers. The S &P is having a great year. So the idea is still further down the line, if and when this mythical recession does hit, and J.P. Morgan Asset Management, among others, are still convinced that that is still going to happen. And at some point further down the chain, there will have to be rate cuts in the US. Then happy day. You can get some capital appreciation out of those bonds if you're still holding them, because they will rise in price. So if you buy bonds, you just have to kind of understand what you're buying them for, what kind of timeframe you're looking at, and they just don't work quite like equities.

8:05That's right. This is kind of the short-term risk, the cyclical risk, the central bank risk. But there's kind of a longer-term risk too, and that's especially concentrated on the longer end of the curve, your 10-year bonds or your 30-year bonds. And that's where do interest rates settle in the long term, right? I think a slightly subtle point that is not always fully understood is that central banks are not fully autonomous institutions, right? These are not organizations that can choose where interest rates are in the long term. They have some ability to manage them higher or lower depending on how they want to steer the economy.

8:37But where rates end up on a 10-year horizon or a 30-year horizon, that's set by much deeper forces in the economy like demography or the role of the government and things like that that are just out of Jay Powell's control. And so there's been a lot of talk recently about what's called, this is jargony, name that's important, the neutral rate, or sometimes called R star. And this is like, you can think of it as like the deepest fundamental economic variable in the economy, which is that this is the interest rate that keeps the economy in perfect balance, as all things should be. It doesn't make inflation worse.

9:09It doesn't hurt growth. But now there's more and more people arguing that maybe the neutral rate is rising. Maybe the economy's kind of fundamental interest rate is higher today after the pandemic than it was in the past decade or so. One big reason for this is the US fiscal deficit, the fact that we are spending$1.5 trillion a year in money that we don't bring in taxes. And what that does is it raises demand for borrowing across the economy, and that pushes interest rates up. There's a bunch of long-term reasons why inflation is kind of, I don't want to use the word broken, but it's not what it was.

9:47You just have to get out of this idea that it's going to go back to being pretty much zero or certainly right two percent or lower you know there are just structural reasons why that's different it's partly fiscal stuff like you were just talking about it's partly an unrelated point is that like the green revolution that's going to cost money it's partly that we live in a kind of scarcity economy now right there's a scarcity of labor food scarcity is cropping up partly as a result of the climate partly as a result of geopolitics you have um you know much kind of clunkier supply chains than they used to be, again, thanks to geopolitics.

10:22So it's a different beast. And broadly speaking, inflation logic will tell you has to be that little bit higher. And that means that the base rates have to be somewhat higher to tackle that. And then I think if you take a really wide view of history, look at a 50-year chart of US interest rates. I mean, where we are today, 5 % nominal rates, not that high, just not. You'd consider this average to low in kind of a previous era? And, you know, there are disanalogies. It's not exactly the same. But I don't think we have reason to think that 5 % interest rates should be terribly high. No, the anomaly was the post-crisis period.

10:59And I can't remember exactly when it was, but the kind of, you know, financial commentary TV stations absolutely lost their mind the first time that US 10-year yields went below 4%. They were saying, what is this crazy world where the 10-year can give you less than 4 %? This just isn't right. And now we've just reset to this whole different way of thinking about where yields should be. Yeah. There's been a lot of talk on Wall Street now that there's all this inflation in the economy that no one's really lived in an environment like that before. And I think maybe in some ways that goes for the process we're seeing now, which is people are new to the idea of leaving the zero rate world and going to a higher rate world.

11:42And there's a lot of parts of the economy, a lot of companies, banks we've seen recently that kind of premised their business models, premised their decision making on the fact that rates were super low for that long. And it's taking time, I think, for people to realize this is a transition period and there may be something different that comes out on the other And it's all confusing because COVID and is the recession coming? And there's a lot of question marks. But I think we have good reason to think that we're not going back to 2015, 2019 or 2011. Yeah, there's this long, slow elegy for Tina for which we have no replacement as an acronym that is taking a little bit of time to get through to everyone's mindsets.

12:25What was it again? It's not gonad. Bonad? What was the acronym? I'm sticking with bonds, buying ordinary notes and debt securities, but again, not catching on. So suggestions, please, to Ethan. Stop trying to make bonds happen. All right, Katie, we'll be back in a moment with Long Short.

12:55Welcome back. This is Long Short, that part of the show where we go long, bet in favor of one thing, and short, bet against something else. I am long Mark Zuckerberg. Now, I don't know if threads, this new kind of social media app that Meta and Zuckerberg are launching, I don't know if that'll catch on. I have no insight into that. But what I will say is that being the second most obnoxious billionaire is a much better place to be than the most obnoxious billionaire. And on a relative basis, markets care about the rate of change, not about the level. I'm long Mark Zuckerberg. He could always get more obnoxious, I guess.

13:31But it is a very tough field, I would say at the moment. On a related note, I'm sure Fintwit, there used to be a really kind of vibrant community of people who knew about finance and markets on Twitter. It feels like it's slightly dying now. I think, you know, people have been peeling away from it for quite a long time. It's becoming a less useful source of information about what's going on in markets. For me, do I have an alternative? No. I've been playing about with Blue Sky and it's fun and there are some interesting people there, but it's still pretty small. So what I do know is that the Fintwit community has kind of been sent to the four corners of the earth.

14:12Are you on threads, Katie? Are you on threads? No. Do you know why? I don't do Instagram. So I think it's an either or thing, isn't it? So for now, I'm team Blue Sky, but I'm not wedded to it. Let's see how it pans out. You know who does have Instagram? grizzled veteran Robert Armstrong. You can talk to him next time then. See if I care. All right, Katie, thanks for being here. We'll have you back next Tuesday. And listeners, we'll be back in your feed for a special episode of Unhedged on Thursday. Catch you then. Listeners, I don't really want to say Bonad, but, you know, we do need an acronym to describe the Postino world.

14:47So if you think you can do better than Bonad, please email me, ethan.wu, W-U, at F-T dot com. Unhedged is produced by Jake Harper and edited by Brian Erstad. Our executive producer is Jacob Goldstein. We had additional help from Topher Forhez. Cheryl Brumley is the FT's global head of audio. Special thanks to Laura Clark, Alistair Mackey, John Schnarz, Eric Sandler, and Jess Trulia. FT Premium subscribers can get the Unhedged newsletter for free. And a 90-day free trial is available to everyone else. Just go to ft.com slash unhedged offer. I'm Ethan Wu. Thanks for listening.