In all the excitement surrounding the passing of the GOP tax bill, we almost missed it.
But on Tuesday, as stocks rose to a record high in anticipation of a huge payoff to corporate America, bonds fell.
The yield on the 10-year Treasury note (which rises as the bond price falls) rose to 2.39%.
That’s up from a record low, recorded in July 2016, of only 1.39%.
Ringing the bell
It is still too early to know for sure. But we wonder. 20 years from now, will we (or someone else) be talking about this moment:
‘It was all so obvious. I don’t understand why no one noticed. After 30 years of easy money policies, central banks switched to tighter money policies. They said so. We should have known the bull market was over. Stocks and bonds were in for a rough ride.’
They say they don’t ring a bell at the top of the market. It’s only later — often many years later — after the background noise dissipates, that you hear it, loud and clear.
If we were listening back in 1980, for instance, we might have heard Fed chief Paul Volcker make an important announcement.
‘That’s the end of the bear market in bonds,’ he said…or words to that effect.
Volcker promised to crush inflation and thereby bring down bond yields and interest rates. Bond prices had to rise. Stock prices, too.
Good to his word, as bond prices rose, the yield on the 10-year Treasury note fell from 14.59% in January 1982 all the way down to the aforementioned 1.39% in July of last year.
And stocks rose from under 1,000 on the Dow to 24,725 today. The entire financial world — including prices, economies, and even our attitudes — was shaped by that 30-year bull market. Now, almost everything in the financial world depends on real rates of interest (adjusted for inflation) staying near zero.
And then we went deaf…
Higher rates ahead
But now, for the first time in three decades, central banks have changed course. And there is a tingling sensation in our inner ears…
Instead of forcing down interest rates, the feds are pressuring both ends of the market — supply and demand — to drive them up.
On the supply side, the new tax bill, combined with higher spending, will require the feds to borrow more. Here’s Bloomberg:
‘Government debt sales are set to more than double in 2018, lifting net issuance to $1.3 trillion, the most since 2010, according to JPMorgan Chase & Co. estimates.
‘With the Federal Reserve shrinking its bond holdings and deficits poised to swell even before taking into account the tax overhaul, all signs point to higher financing costs…dealers see issuance rising for years to come.
‘With entitlement costs heading higher, the U.S. debt burden was already projected to increase by $10 trillion in the next decade. Now, the [GOP] tax overhaul could boost the deficit by $1 trillion in the period.’
Also on the supply side, worldwide bond issuance hit a record high in 2017 — at $6.8 trillion. More than half of that borrowing was done by corporations.
Presumably, corporate finance officers are eager to issue more debt while the getting’s good and borrowing costs are still low.
They anticipate higher rates to come…and fewer lenders.
The end of stimulus
Which brings us to the demand side…
Over the last 30 years, central banks have pushed down interest rates…and pushed up demand for bonds. Since 2009, they’ve been the biggest buyers of bonds in the world.
They are now becoming the biggest sellers. Next year, the Fed has said it will cut its $4.5 trillion of bond holdings (purchased under its QE programs) by about $250 billion.
By the end of the year, that figure will rise to $600 billion a year.
Altogether, it has pledged to reduce the bonds on its balance sheet by more than $2 trillion.
The Fed began unwinding QE two months ago. So far, it has had no effect on stocks…and little effect on bonds. Buying has been sustained by foreign central banks and pension funds.
But that seems to be coming to an end, too.
End of the world
Central bankers and pension fund managers all read the same reports…go to the same schools…and believe the same quack theories.
And they all protect their currencies, funds, and economies from each other.
When the US pumped in credit…the others had to pump it in, too. Now, the US central bank is draining liquidity rather than adding to it; they must do some mopping up.
The European Central Bank, headed by former Goldman guy Mario Draghi, is now talking about ‘tapering’ its QE (bond buying) program.
Another big source of global liquidity came from China, the biggest foreign market for US debt.
Earlier this year, China was eager to goose up its economy in advance of its coronation of Xi Jinping as the most powerful Chinese leader since Mao…and build up its foreign exchange reserve to support the yuan.
Now, the 19th National Congress of Communist Party of China — its once-every-five-years policy-setting meeting — is history…and the yuan has stabilised. And like the Fed, the Chinese authorities are reversing the easy-money policies that created a dangerous overhang of debt.
And what’s that sound now? Is it a bell ringing? Or just more noise?
Goldman Sachs hears something. It expects yields on the 10-year Treasury to rise to over 3% by the end of next year.
Who knows… Maybe we’ll see 4%…and the end of the world as we know it.
For Markets & Money