Note: I am travelling this month. Posting will be sporadic and shorter due to limited time and equipment.
Rising Interest Rates Mean Deficits Finally Matter Investors ignored deficits when inflation was low. Now they are paying attention and getting worried.
(…) No, the U.S. isn’t about to default or fail to sell enough bonds at its next auction. But the scale and upward trajectory of U.S. borrowing and absence of any political corrective now threaten markets and the economy in ways they haven’t for at least a generation.
That’s the takeaway from the sudden sharp rise in Treasury yields in recent weeks. The usual suspects can’t explain it: The inflation picture has gotten marginally better, and the Federal Reserve has signaled it’s nearly done raising rates.
Instead, most of the increase is due to the part of yields, called the term premium, which has nothing to do with inflation or short-term rates. Numerous factors affect the term premium, and rising government deficits are a prime suspect. (…)
“We had a blissful 25 years of not having to worry about this problem,” said Mark Wiedman, senior managing director at BlackRock.
Today, though, central banks are worried about inflation being too high and have stopped buying and in some cases are shedding their bond holdings (“quantitative tightening”). Suddenly, fiscal policy matters again.
To paraphrase Hemingway, deficits can affect interest rates gradually or suddenly. Investors, asked to buy more bonds, gradually make room in their portfolios by buying less of something else, such as equities. Eventually, the risk-adjusted returns of these assets equalize, which means higher bond yields and lower price/earnings ratios on stocks. That has been happening for the past month. (…)
Could a point come when “all the headlines will be about the fiscal unsustainability of the U.S.?” asked Wiedman. “I don’t hear this today from global investors. But do I think it could happen? Absolutely, that paradigm shift is possible. It’s not that no one shows up to buy Treasurys. It’s that they ask for a much higher yield.” (…)
The federal deficit was over 7% of gross domestic product in fiscal 2023, after adjusting for accounting distortions related to student debt, Barclays analysts noted last week. That’s larger than any deficit since 1930 outside of wars and recessions. And this is occurring at a time of low unemployment and strong economic growth, suggesting that in normal times, “deficits may be much higher,” Barclays added. (…)
The WSJ’s Nick Timiraos:
- Bond Selloff Threatens Hopes for Economy’s Soft Landing Growth prospects and concern over government debt are driving long-term interest rates higher
Treasury Secretary Janet Yellen said Tuesday that it wasn’t clear whether bond yields would settle out at higher levels over the long run. “It’s a great question, and it’s one that’s very much on my and the administration’s minds,” she said during a moderated discussion at the Fortune CEO Initiative conference in Washington. (…)
A higher term premium means even if inflation is under control, borrowers will have to pay more than before because investors want extra compensation for the risks associated with locking up their money for longer periods.
A sustained rise in Treasury yields will be costly for the U.S. government because it would face still-higher borrowing costs on a much larger stock of its debt. The publicly held debt of the U.S. has doubled to around $26 trillion over the past eight years.
The run-up in borrowing costs is sending mortgage rates to 23-year highs, with more lenders now quoting rates above 7.5% for the 30-year fixed loan. Higher borrowing costs could weigh on stocks and other asset prices, leading to weaker investment, hiring and economic activity. (…)
Economists at Goldman Sachs estimate that if the tightening in financial conditions that began in late July is sustained, it could reduce economic output by 1 percentage point over the coming year.
That could weaken the case for the Fed to raise interest rates later this year. “We’re going to have to watch it,” Cleveland Fed President Loretta Mester told reporters Tuesday. “Those higher rates will have an impact on the economy, and we just have to take that into account when we’re setting monetary policy.” (…)
The current run-up in bond yields gained momentum at the end of July, when the economy began to show signs of reacceleration in the midst of stronger-than-expected consumer spending. Since then, investors and Fed officials have scrapped their projections that the economy would stumble.
Fed officials have raised their expectations for economic growth next year because “underlying momentum in the economy is quite a bit stronger than we thought…and I think that’s also what market participants are doing,” said Mester. (…)
Investors are puzzling over why consumption has been strong despite the Fed’s aggressive rate increases. If it is because the neutral rate is higher, the Fed will keep rates higher for longer, justifying the recent run-up in yields. If it is because the traditional lags of monetary policy simply haven’t kicked in, then it could be just a matter of time before the economy slows.
“More people were in the lags camp six months ago, and they’ve slowly thrown in the towel on that one,” said Priya Misra, portfolio manager at J.P. Morgan Asset Management. “They are reassessing how long the Fed will have to keep rates here.” (…)
A strong September employment report this Friday could add to the bond-market rout by underscoring the economy’s resilience, which would push yields higher. On the other hand, signs of weakness could halt the rise in yields. (…)
Only a Stocks Crash Can Rescue the Bond Market, Barclays Says
Global bonds are doomed to keep falling unless a sustained slump in equities revives the appeal of fixed-income assets, according to Barclays Plc.
“There is no magic level of yields that, when reached, will automatically draw in enough buyers to spark a sustained bond rally,” analysts led by Ajay Rajadhyaksha wrote in a note. “In the short term, we can think of one scenario where bonds rally materially. If risk assets fall sharply in the coming weeks.” (…)
“The magnitude of the bond selloff has been so stunning that stocks are arguably more expensive than a month ago, from a valuation standpoint,” they wrote. “We believe that the eventual path to bonds’ stabilizing lies through a further re-pricing lower of risk assets.”
John Authers:
What’s Worse Than an Inverted Yield Curve?
For 15 months now, the yield curve has been inverted. In English, that means 10-year Treasury bonds have been yielding less than two-year bonds, even though investors normally require an extra yield for the extra risk for investing over long periods. As is now widely known, an inverted curve is one of the strongest recession indicators there is. An inversion so protracted implies serious problems afoot.
The spike in bond yields over the last few weeks, however, has been accompanied by a swift dis-inversion. The curve was inverted by 107.5 basis points (meaning that two-year exceeded 10-year yields by this much), as recently as July. Now that number has dropped to 31.7 basis points, the least inverted curve in almost 12 months:
And this is a shame, because the yield curve tends to dis-invert when the recession is about to start. (The intuition behind why this might be is that when a downturn is clearly imminent, central banks begin to cut rates, bringing down shorter-dated bonds.) The following chart from Joe Lavorgna of SMBC Nikko confirms both that the curve inverts before each recession and also that the inversion is usually over by the time the recession, as officially defined by the National Bureau of Economic Research, begins:
This sounds scary. But now we need to add another element. As discussed, curve dis-inversions often happen because shorter yields come down. In the jargon, that is a “bull steepening,” because a rise in two-year prices (bullish if you hold them) leads to the flattening. This one is different. It’s a bear steepening, meaning that the move has been driven by a fall in the price of long-dated bonds. Further, this is a specific kind of bear steepening that starts with the curve inverted.
That combination of conditions happens very rarely. When it does, the following chart from Capital Economics demonstrates that a recession generally soon follows. For markets, Capital Economics concludes, such bear steepenings have generally “been followed by significant falls in long-term government bond yields, as well as equity indices.”
But why exactly should we care about the yield curve? Theoretically, by making it harder for banks to make profits, it’s causative. The inverted curve can bring about a recession. But banks are less central to the financial system than they once were. The inverted curve is an issue for financiers, but it hasn’t significantly affected the everyday financial conditions for most families and companies. It’s possible, even, that it’s now become a false indicator. Now that the significance of an inverted curve is well known, it can change behaviors — and thus dampen the risk of a recession. (…)
Bottom line: It would still be very surprising if we escaped from this economic hole without a recession. The speed with which the curve is now steepening suggests, all else equal, that the downturn is close. But nothing is certain.
I would normally begin the post with the PMIs but I thought the discussion on interest rates should lead today. One, because it reflects the new puzzlement that rates can actually rise, even when inflation is easing. Two, because I was truly amazed that none of the major news media headlined the U.S. Services PMIs (at least at 3:00am EST). And only the FT noted yesterday’s big drop in oil prices.
SERVICES PMIs
S&P Global: U.S. service sector stagnates in September, as demand conditions wane further
The seasonally adjusted final S&P Global US Services PMI Business Activity Index posted 50.1 in September, down from 50.5 in August and broadly in line with the earlier released ‘flash’ estimate of 50.2. The latest data signalled a broad stagnation in business activity following seven successive months of growth in output. Despite some reports of sustained inflows of new business, companies highlighted that elevated inflation, high interest rates, and economic uncertainty all stymied customer demand.
September data indicated a continued decline in new business at service sector firms. The rate of contraction quickened to the sharpest since December 2022, albeit still modest overall. Lower new orders were reportedly linked to weak domestic and foreign client demand, with new export orders falling for the first time in five months. The decrease in new export sales was the steepest since February and was in stark contrast to the solid expansion seen in July.
Although slower than the series average, service providers saw a further rise in employment during September. Staffing numbers have risen in each month since July 2020, with the latest uptick the fastest for three months. Alongside efforts to clear backlogs, firms noted that greater workforce numbers on the month were often due to the replacement of previous voluntary leavers.
Expanded capacity and a reduction in new orders allowed firms to work through their backlogs again. The level of incomplete business fell for the fourth time in the last five months and at the quickest rate since November 2022.
On the prices front, input costs rose at a further marked pace, with the rate of inflation similar to that seen in August. Panellists stated that higher energy, fuel, wage and food costs drove the latest increase in business expenses. The pace of cost inflation remained above the long-run series average.
In line with another substantial uptick in cost burdens, service providers hiked their selling prices in September. The pace of charge inflation accelerated to the fastest since July as firms sought to pass through greater costs to customers.
Finally, service sector businesses expressed positive expectations regarding the outlook for output over the coming year. The degree of confidence matched that seen in August but remained below the series trend. Optimism was pinned on investment in new service lines and greater marketing, as well as hopes of stronger customer demand, according to panellists.
The final S&P Global US Composite PMI Output Index posted 50.2 in September, unchanged from the figure seen in August. The latest data signalled broadly unchanged business activity across the US private sector, despite a return to modest output growth in the manufacturing sector.
Contractions in new business at manufacturers and service providers led to a sharper overall decrease in new orders during September. At the same time, new business from abroad fell at a marginal pace. Although slower than the average seen in the post-pandemic period, input prices and output charges increased at faster paces than in August. Higher oil prices reportedly pushed up material and transportation costs at manufacturers and service providers.
Despite weak demand conditions and a faster drop in backlogs of work, employment continued to rise. The increase in staff numbers was modest overall and the quickest since June. Meanwhile, firms were more optimistic in their expectations for output over the coming year in September, largely driven by an uptick in confidence at manufacturing firms.
ISM Services Slips in September
Service sector activity expanded at a slower pace in September. The overall ISM services index slipped to 53.6 last month. While that is down from a month earlier, it remains higher than its past six-month average and is still broadly consistent with expansion.
The measure of current activity rose to 58.8, suggesting a faster pace of growth. But there were some signs of caution within the other components. For starters, the new orders component slumped 5.7 points to 51.8, or the lowest in nine months, signaling a loss of demand. Twelve of 18 industries did report an expansion of orders, but selected comments referenced “slightly lower number of new projects” and “decreased guest traffic” demonstrating somewhat of a slowdown. Order backlog also jumped 6.8 points, but at 48.6, remained consistent with a contraction in backlog. (…)
The employment component came in at 53.4, which is consistent with a more moderate pace of job growth in September. (…)
So demand for services has slowed markedly with weak new orders confirming that this might not be a one-month thing. If so, the economic reacceleration may be over and may just have been the last bout of revenge spending.
Oil plunges $5 in biggest one-day drop in more than a year
Just for fun (!), I present these 2 charts:
- 10Y Treasury yields and the Cleveland Fed’s real 10Y interest rate. The Federal Reserve Bank of Cleveland estimates the expected rate of inflation over the next 30 years along with the inflation risk premium, the real risk premium, and the real interest rate. Their estimates are calculated with a model that uses Treasury yields, inflation data, inflation swaps, and survey-based measures of inflation expectations.
- A simpler measure of real yields: 10Y Treasury yields minus core PCE inflation (YoY). The red dash line is set at 2.0%. If the Fed gets inflation to 3.0%, the current real yield = 1.8%. At 2.5% inflation, real yield = 2.3%. FYI.
Sunrise in Lisbon while writing this post:
