Since August 2020, the 10-year US Treasury bond has seen a rise in yields from 0.51% to 1.75%, marking the biggest bear market in US bonds since the infamous “taper tantrum” of 2013, when the Fed announced a reduction in the pace of its buying of US bonds.
The reasons are by now well known, with traders fretting about the passing of President Biden’s $1.9 trillion COVID relief plan, to be followed in short order by a $3-4 trillion Infrastructure package announcement.
Bond traders appear to be concerned that all this stimulus will arrive at the same time as the economy re-opens, leading to a surge in inflation with the likelihood of interest rate rises being forced upon a reluctant Federal Reserve.
Government spending already appears to be out of control, even on Congressional Budget Office predictions and they do not factor in the possibility of recession. Buried in the CBO projections is the statement:
“Interest spending will be the largest federal program by 2045”.
Bond traders have taken note- 5-year inflation expectations have surged from 0.2% a year ago, to 2.64% now.
Primary bond dealers, who deal directly with the Fed sold a net $65 billion in US Treasuries in the week ending March 3rd, a 25% rise on the previous week, as they collectively wonder who will buy all the bonds the US will need to sell in the coming months.
The Fed has some options, most of which are bullish for bonds.
- The Fed could intervene in bond markets with a version of Operation Twist – buying 10 year Treasuries, while selling shorter dated bonds. This flattens the yield curve, thereby helping both longer dated bonds AND equities.
- Introduce yield curve control. This would, depending on the rate chosen to pin yields, would be very bond bullish short term. But it is similar to a foreign exchange rate peg and as the UK found in 1993 with the ERM, it makes a loud noise when it breaks.
- Allow interest rates to rise without hinderance. This is highly unlikely- the failure to intervene risks yet higher interest rates which are incompatible with current high debt levels, potentially leading to another recession, which is positive for bonds.
Furthermore, US equities are now highly correlated with US Treasuries and the continuance of the bull market in shares is predicated on low interest rates, an end to which implies the end of the bull market too.
The Fed has made it clear that it wants the “wealth effect” of rising equities to help sustain the economy and thus will not allow prices to fall substantially without reacting.
We can expect buying from both foreigners and pension funds to emerge soon.