BM Pro Daily - A Reversal In Rising Yields
U.S. 10-Year Peaks At 3.19%
In previous issues, we’ve highlighted the unique pace and period of rising interest rates as the U.S. 10-year treasury bond went from 1.35% to 3.19% at its recent peak in less than six months. Now over the last few weeks, we’ve seen a sharp reversal in interest rates, especially longer duration, as markets seem to be pricing in lower long-term inflation expectations and the rising probability of a more deflationary market regime on the horizon. The U.S. 10-year treasury yield has fallen over 50 basis points to around 2.78%.
The recent rally in bonds could be caused by a few different factors, with the most obvious being the large institutional players such as pension funds that are (and have been) in desperate need of yield. The second factor at play could be the impending economic slowdown taking place in the United States, as bond investors (often touted as being the smart money) front run a slowdown in consumer spending and inflation expectations.
Five-year, five-year forward inflation expectations is the bond market's expectation for the next five years on average, since April 21, 2022, expectations have fallen from a high of 2.67% to 2.24% today. While one can certainly argue that past expectations were off base, these are some of the metrics that the largest pools of capital in the world base their decisions off of.
With the fall in bond yields, equity indices have rebounded, with the S&P 500 currently trading 6.7% off of its May 20 lows. With bonds and equities bouncing off the local lows, the looks of a prototypical bear market rally seem to be in the works.
Similarly, average 30-year fixed mortgage rates saw their largest drop since April 2020, falling to 5.10%, still far above rates over the previous two years.
The signal in rates is telling. An inflationary crisis that has spurred global monetary tightening looks to be beginning its transition to a bust. While this transition won’t happen overnight, policy makers are likely to find out the hard way that, at tremendously elevated levels of debt-to-gdp, asset markets are the U.S. economy.
Final Note
While forward inflation expectations for the next five years are sitting at 2.24%, current year over year consumer price inflation is 8.22%, meaning the real yield on all global fixed income instruments have been deeply negative. This dynamic has been a large focus of our research over the previous year, and due to global debt levels, this will need to persist.
As highlighted in our October 12 issue, the focus of our issue was the International Monetary Fund (IMF) research paper released in 2011 titled, “The Liquidation of Government Debt.” Central banks and monetary authorities have long understood the reality that public and private debt levels relative to productivity were far too high, and the only way to resolve the issue was through financial repression.
A quote from the paper’s abstract is as follows,
“Historically, periods of high indebtedness have been associated with a rising incidence of default or restructuring of public and private debts. A subtle type of debt restructuring takes the form of ‘financial repression.’ Financial repression includes directed lending to government by captive domestic audiences (such as pension funds), explicit or implicit caps on interest rates, regulation of cross-border capital movements, and (generally) a tighter connection between government and banks. In the heavily regulated financial markets of the Bretton Woods system, several restrictions facilitated a sharp and rapid reduction in public debt/GDP ratios from the late 1940s to the 1970s. Low nominal interest rates help reduce debt servicing costs while a high incidence of negative real interest rates liquidates or erodes the real value of government debt. Thus, financial repression is most successful in liquidating debts when accompanied by a steady dose of inflation.”
Eventually the fixed income market, which is over $100 trillion in size, will come to understand the realities of sustained financial repression and what it means for the purchasing power of the contracts held by the creditors purchasing them.
In 2022, the liquidity tide has been pulling back. In due time, the tide will reverse, solely based on the realities of a debt-based monetary system. Every rational investor will be searching for a safe haven for their capital.