Shot Across the Bow
Doug Nolan
The two-year versus 10-year Treasury spread narrowed 20 bps this week, the largest narrowing since the banking crisis week of March 17th.
Ten-year Treasury yields rose eight bps for the week to 4.03% - after trading up to 4.20% early-Friday following the release of July payroll data.
This was within two bps of the October 21st high – which was the peak yield back to June 2008.
Benchmark MBS yields traded above 6% in early-Friday trading for the first time since the (UK bond dislocation) October yield spike.
MBS yields reversed a notable 26 bps in volatile Friday trading, ending the week up six bps to 5.74%.
Long-bond yields surged a notable 19 bps this week to 4.20% (high since November).
Meanwhile, two-year yields dropped 11 bps to a near three-week low 4.77%.
The market probability for a 25 bps rate increase at the Fed’s September 20th meeting dropped from 19% to 13%.
It’s an interesting market dynamic when bond yields are at the cusp of breaking higher, yet shorter-term yields declined, along with expectations for higher policy rates.
A “risk off” tenor took some pressure off short rates.
Investment-grade corporate CDS gained 5.6 bps this week – the largest increase since March (to a still relatively low 68 bps).
High-yield CDS jumped 27.3 bps, second only to the week of June 23rd (27.6 bps) for the largest weekly gain since March.
Curiously, “risk off” extended to the hot emerging markets.
It’s always interesting to see the familiar list of EM currencies quickly under pressure when global risk aversion makes an appearance.
Even after Friday’s rally, the week’s losses were meaningful.
The South African rand declined 4.5%, the Russian ruble 3.9%, the Colombian peso 3.7%, the Brazilian real 2.9%, the Chilean peso 2.7%, the South Korean won 2.5%, and the Peruvian sol 2.4%.
The Mexican peso’s 1.4% Friday advance cut losses for the week to 2.3%.
The emerging market equities EFT (EEM) dropped 3.3%, while EM bonds (EMB) declined 1.1%.
EM CDS rose 11 bps this week, the largest weekly increase since April.
EM dollar bonds were under notable selling pressure.
Yields were up 23 bps in Panama (to 6.02%), 22 bps in Turkey (8.13%), 20 bps in the Philippines (4.95%), 19 bps in Indonesia (5.01%), and 18 bps in Peru (5.33%).
Surging to highs since March, yields rose 20 bps in Brazil (6.07%) and 16 bps in Mexico (5.62%).
Local currency EM yields surged 29 bps in Colombia (10.41%), 25 bps in Romania (6.70%), 21 bps in Hungary (7.42%), 19 bps in Mexico (8.99%), and 17 bps in Peru (6.89%).
Germany’s DAX equities index dropped 3.1%, with major indices down 2.2% in France, 3.1% in Italy, 3.3% in Spain, and 1.7% in the UK.
Down 2.2%, it was the largest weekly loss for the S&P500 since March.
Curiously, the Utilities were slammed 4.7%, the biggest drop since last September.
The Nasdaq100 fell 3.0%, the largest decline since the week of the SVB failure (March 10th).
Apple’s 4.8% Friday slump boosted losses for the week to 7.1% (largest since November).
It’s worth noting that Apple closed Monday trading at an all-time high, at that point with a y-t-d return of 51.6%.
The company Thursday reported fiscal Q3 Net Income of $19.881 billion, up 2% vs. Q3 2022.
Revenues were down slightly y-o-y.
The stock closed the week with a price-to-earnings ratio of 30.59.
It seems like the market this week was infected with a touch of reality.
ISM and PMI surveys pointed to ongoing U.S. service sector strength.
The ISM Services Price Paid Index rose 2.7 points to 56.8, the high since April.
Employment data (non-farm payrolls, ADP, weekly claims) all pointed to ongoing labor market strength.
August 2 – Bloomberg (Jeff Cox):
“Private sector companies added far more jobs than expected in July, pushed higher by a boom in leisure and hospitality jobs, payroll processing firm ADP reported…
Job gains for the month came to 324,000, driven by a 201,000 jump in hotels, restaurants, bars and affiliated businesses.
That total was well above the… estimate for 175,000…
Services-related industries dominated job creation during the month as the economy continues its transition back from being goods-oriented in the early days of the Covid pandemic.
The sector was responsible for 303,000 jobs on the month.”
The July Unemployment Rate declined a tick to 3.5%, near the lowest level since 1969.
Notably, Average Hourly Earnings gained a stronger-than-expected 0.4% during July, with y-o-y growth of 4.4%.
June and July’s back-to-back months of 0.4% increases were the first of the year, as data point to a re-acceleration of wage gains.
It’s worth noting that y-o-y Average Hourly Earnings gains peaked in 2007 at 3.5% - and in 2008 at 3.6%.
Gains averaged 2.6% during the decade 2009 through 2018.
Average Hourly Earnings had accelerated to 3.2% during 2018 and 2019, momentum that pandemic stimulus supercharged.
Bonds have every reason to be nervous.
It didn’t help that Fitch dropped their AAA rating on U.S. debt.
August 2 – Reuters (Davide Barbuscia):
“Fitch downgraded the U.S. credit rating due to fiscal concerns, a deterioration in U.S governance, as well as political polarization reflected partly by the Jan. 6 insurrection, Richard Francis, a senior director at Fitch Ratings, told Reuters…
In a move that took investors by surprise, Fitch downgraded the United States to AA+ from AAA on Tuesday, citing fiscal deterioration over the next three years and repeated down-to-the-wire debt ceiling negotiations that threaten the government’s ability to pay its bills.”
August 2 – Bloomberg (Christopher Condon):
“Treasury Secretary Janet Yellen… slammed the move by Fitch Ratings to strip the US of its top-tier credit rating, calling it ‘flawed’ and ‘entirely unwarranted.’
‘Fitch’s decision is puzzling in light of the economic strength we see in the United States,’ Yellen said…
‘In the longer term, the US ‘remains the world’s largest, most dynamic, and most innovative economy – with the strongest financial system in the world.’”
Former Treasury Secretary Larry Summers:
“The idea that this is creating the risk of a default on US Treasury securities is absurd, and I don’t think that Fitch has any new and useful insights into the situation.”
Mohamed El-Erian:
“We don’t have a debt problem as long as growth continues to pick up, and one of the upside surprises has been not only that actual growth has picked up, but that potential growth is starting to be positively impacted by policy.”
“Why now?
You scratch your head as to the timing of this.”
A few of my favorite headlines:
“Here’s Why Top Economists Are Calling Fitch’s Decision to Downgrade America’s Credit Rating ‘Bizarre and Inept’.”
“Massive Backlash Over U.S. Credit Rating Downgrade Forces Fitch into Defense Mode.”
“Credit Downgrade Shocks Biden Aides, as More Debt Fights Loom.”
Thou doth protest too much.
And despite all the Wall Street and Washington pushback against Fitch’s decision, Treasury debt has inflated from $6 TN to $27 TN since the end of 2007 – growing from about 40% of GDP to over 100%.
And why downgrade now?
At $1.4 TN, the federal deficit for the first nine months of the fiscal year was up 170% from comparable 2022.
July 31 – Bloomberg (Liz Capo McCormick):
“The US Treasury boosted its estimate for federal borrowing for the current quarter, as it addresses a deteriorating fiscal deficit and keeps replenishing its cash buffer.
The Treasury Department increased its net borrowing estimate for the July through September quarter to $1 trillion, well up from the $733 billion amount it had predicted in early May.
The new amount… is a record for the September quarter and in excess of what some close watchers of the figure had expected.”
The deterioration in our nation’s fiscal position is shocking, especially during a period of economic expansion.
The CBO is projecting a 2023 deficit of about 6% of GDP.
A reasonable scenario that includes persistent inflation forcing “higher for longer” and surging debt service, recession and sinking revenues, rising defense spending and such could easily see deficits approach 10% of GDP.
Major bank failures and GSE recapitalization would push the number even higher.
And who has any confidence that Congress could come to bipartisan agreement on how to manage through a fiscal crisis?
August 2 – Reuters (Urvi Dugar and Megan Davies):
“Ratings agency Fitch… downgraded U.S. mortgage finance giants Fannie Mae and Freddie Mac Long-Term Issuer Default Ratings (IDR) and senior unsecured debt ratings to 'AA+' from 'AAA' after the U.S. rating downgrade…
‘The downgrade to the ratings of Fannie and Freddie was a certainty after Fitch's downgrade of the US rating since the two ratings are linked,’ said Gennadiy Goldberg, Head of US Rates Strategy at TD Securities.”
I tend to see Fitch’s timely downgrade as a Shot Across the Bow.
It might take a while – even a very long while – but, at the end of the day, fundamentals matter.
Fundamentals should be troubling to the bond market these days.
Inflation appears more persistent than it has been in a long time, supporting the New Cycle thesis.
Massive deficits ensure a massive supply of Treasuries as far as the eye can see.
And “higher for longer” ensures heightened risk for both higher rates and QT.
There is also the risk of problematic deleveraging and derivatives-related selling overwhelming the marketplace.
And we cannot today disregard risks unfolding in Japan.
July 31 – Financial Times (Kana Inagaki, Leo Lewis, Mary McDougall and Katie Martin):
“Japanese government bond yields jumped on Monday as global debt, currency and equity markets began to absorb a landmark shift by the Bank of Japan to allow yields to rise more freely.
Analysts said BoJ governor Kazuo Ueda’s decision to loosen the central bank’s grip on long-term bond yields marked a significant step towards unwinding decades of ultra-accommodative monetary policy.
The benchmark yield on 10-year JGBs rose to a nine-year high...”
August 1 – Bloomberg (Garfield Reynolds):
“The Bank of Japan is seeding uncertainty across global markets with a radical shift to its policy settings.
The likely outcome is higher volatility and bond yields both in the Asian nation and around the world.
The potential impact is set to be extensive given Japanese portfolio investors hold some ¥308.4 trillion ($2.2 trillion) of overseas debt…”
My analytical interests are piqued by big “bear steepeners” – when long-term rates jump and shorter rates decline.
It has me contemplating a New Paradigm.
The old paradigm goes back a while – sowed in the days of Greenspan and fully embraced with Bernanke.
It unfolded gradually – then quickly.
Bond pricing evolved to be dictated more by prospects for Fed policy stimulus than by underlying fundamentals (i.e., inflation and supply).
Market became highly distorted and dysfunctional.
There’s a strong argument that this dysfunction turned even more pronounced during the Fed’s current “tightening cycle” – that has failed to tighten financial conditions.
It’s worth noting that 10-year bond yields reached 8% during the last true tightening cycle in 1994 – despite inflation lower than today.
The bond market has largely disregarded the risk of entrenched inflation and has been quick to price in prospective Fed rate cuts.
After the restart of QE in 2019, $5 TN of Covid QE, and the recent bank crisis response, it’s understandable that bond pricing has reflected the near certainty of ongoing aggressive monetary stimulus.
Bond market dysfunction has perpetuated loose conditions and accommodated massive fiscal deficits.
A distorted marketplace has incentivized both leveraged speculation and dangerous derivative structures.
In short, the bond market has been sowing the seeds of its own crisis for a long time.
It has been inevitable.
It’s so long overdue.
Bond focus appears to be pivoting to the risk of sticky inflation and a more prolonged Fed tightening cycle.
This week’s shift to “risk off” saw two-year note yields drop.
Such a backdrop would have typically also spurred buying of longer maturities and resulting lower yields.
But bond market focus has shifted to other concerns – the type of concerns that in the past would have been a source of bond and market grief.
Bond and MBS yields rose Friday morning to key levels - and then recoiled.
Unless “risk off” gains momentum, bonds are vulnerable here.
We could be witnessing the start of an important paradigm shift.
August 4 – Bloomberg (Matthew Boesler, Craig Stirling and Paul Abelsky):
“No amount of power and prosperity can stop the irritation of getting judged for your borrowing habits, as the world’s biggest economy just experienced.
The US downgrade from AAA by Fitch Ratings this week is just the most high profile episode in a new era of scrutiny over global public finances that deteriorated in the wake of the Covid pandemic.
Rich-world peers from Italy to France and the UK are in the spotlight as higher interest rates impact debt levels exceeding 100% of annual output.
Stakes are even higher for capital-hungry developing nations, where potentially ill-timed, negative revisions can push up borrowing costs for years.”
August 2 – Bloomberg (Liz Capo McCormick):
“It’s taken more than a decade, but David Beers is feeling something like vindication after Fitch Ratings downgraded US government debt this week.
The former head of S&P Global Ratings’ sovereign debt scoring committee was one of the analysts behind the controversial decision to cut the US credit grade back in 2011.
He warned… that issues dogging the world’s top economy now are reminiscent of those that drove S&P’s downgrade 12 years ago — and some have escalated.
That includes political brinkmanship surrounding the US debt ceiling.
‘The underlying fiscal position and underlying debt trajectory has picked up pace,’ Beers… said... ‘AAA is the top rating any rating agency can assign, but of course, the US and any other sovereign that’s being rated has no god-given or automatic right to that.’”
August 2 – Bloomberg (Christopher Anstey):
“Two former US Treasury secretaries urged Washington policymakers to address the country’s long-term fiscal challenges before they become insurmountable…
‘Our fiscal trajectory is concerning,’ Hank Paulson said...
‘We’re a rich country, and we’ve got time to deal with it. But we need to do some things in the next few years to change that trajectory.’
Paulson’s successor as Treasury chief, Timothy Geithner, said ‘you want to move the system to act before it’s late and hard.’
Asked whether it would take a crisis before Washington did address its borrowing needs, he answered, ‘I hope not.’”
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