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Political dysfunction. Government bond yields spiking. A market so thoroughly rattled it required the central bank to intervene.
That was the U.K. in October 2022. Does a similar sequence await the U.S. a year later?
Some observers are worried that it might, after Treasury yields midweek surged to fresh multi-year highs amid further evidence of a sturdy economy that may encourage the Federal Reserve to raise interest rates again.
Extra propulsion was seen coming from political risk, after Kevin McCarthy was removed as Speaker of the U.S. House of Representatives, an unprecedented move that may make it more difficult for Washington to reach a budget deal by the new November deadline.
The 10-year Treasury yield
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early Wednesday stood only about 10 basis points from the 5% level, and the 30-year
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breaching that milestone for the first time since August 2007. The 10-year Treasury was yielding less than 3.4% as recently as May.
“I struggle to see how the recent yield moves don’t increase the risk of an accident somewhere in the financial system given the relatively abrupt end over recent quarters of a near decade and a half where the authorities did everything they could to control yields… risky times,” said Jim Reid, strategist at Deutsche Bank.
Reid, who is based in London, saw up close how such a confluence of political, monetary and market conditions can create an explosion.
The ‘mini budget’ of U.K. Prime Minister Liz Truss and her finance minister Kwasi Kwarteng, presented last autumn was slammed for promising un-funded tax cuts at a time when the government finances were stretched and the Bank of England was trying to damp double-digit inflation.
Bond investors, seeing the need for more debt to fund the tax cuts, and the likelihood that any resulting consumer spending boost might force the central bank to raise interest rates further, started selling, forcing yields sharply higher.
But what was an understandable reaction to an unexpected fiscal and monetary shift, turned into a rout as pension funds exposed to a highly-geared bond derivative trade became forced sellers. The 10-year gilt yield
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at one stage surged more than 120 basis points in just four sessions, prompting the Bank of England to step in and buy bonds amid fears many pension funds faced margin calls that could leave them bust.
The U.K. bond market volatility affected global market sentiment negatively for a while, but was relatively contained, but what if the recent selling in the $25 trillion Treasury sector reveals an underappreciated rupture in a corner of the U.S. market?
There are similarities between the U.K’s 2022 scenario and the U.S. now. Political fracture is an obvious one. Liz Truss was the fourth U.K. Prime Minister in six years as the Conservative Party tore itself apart over Brexit. The removal of McCarthy comes ahead of what is expected to be a very divisive U.S. 2024 presidential election.
Such shenanigans can be a problem when you are trying to sell a lot of your debt to the world. “Another flap over the debt ceiling is a reminder that America has added over $1.5 trillion in government borrowing since April’s debt deal on Capitol Hill, and that the interest bill on the $33 trillion federal debt mountain is now running at an annualized rate just shy of $1 trillion,” says Russ Mould, investment director at AJ Bell.
Indeed, the Treasury is looking to raise some $850 billion in the fourth quarter alone. As Nicholas Colas, co-founder of DataTrek says, one explanation for why yields have surged of late is that “markets have suddenly woken up to the fact that the U.S. government’s deficit spending is unsustainably high, especially now that long term interest rates are at +15-year highs.”
Where the U.S. seems to differ is that the pension sector is less focused on bonds than its U.K. cousin, but as the 2008 financial crisis showed, there are myriad ways for Wall Street to trip itself up. Some observers are worried about the ‘basis trade’, which sees hedge funds highly exposed to a Treasury-linked derivatives bet.
Such positioning may be a problem alluded to by market commentator Jim Cramer.
“The forced selling will continue in bonds until it is revealed who is too levered and blows up, probably when the 30 year yield exceeds the fed funds rate as it should on normal steepening,” Cramer said on X, on Wednesday.
“But one final thought, let’s not kid ourselves. Many banks [share prices] are approaching their March lows, and the vultures are sensing that someone out there could be a Silicon Valley Bancorp…The group never really recovered….,” Cramer added.
When the U.S. regional bank collapse hit SVB in March it encouraged the federal authorities to step in and provide support. Equity bulls may hope that the problems caused by surging yields this time around don’t require Fed intervention, but perhaps it may make the central bank a bit less likely to maintain its hawkish tone. The market would like that.
