Why this is the only chart that matters right now

This column has no desire to be seen as a broken clock, stuck and chiming at the same time each day, but it remains convinced that the only chart that matters right now in financial markets is the one that shows the yield on the US ten-year Treasury, or government bond (see this column,30 Jun ’23 and 14 Jul ’23).

US ten-year yields reached a sixteen-year high before the war in Gaza

Source: Refinitiv data

The US ten-year’s vertiginous rise seems to be in abeyance for now, presumably as a result of investors’ search for a haven while they watch events in the Middle East and wonder what the implications are, from the narrow perspective of asset prices. This halt in the ten-year yield is welcome (even if the reasons for it are dreadful and a speedy, peaceful resolution to the Gaza conflict would be cheered by all) but there are three reasons for its advance and three reasons why it matters so much. Investors need to keep a close eye on them all.

Yield of dreams

“The acceleration in the US ten-year Treasury yields since spring looks to have its origins in three trends.”

The acceleration in the US ten-year Treasury yields since spring looks to have its origins in three trends:

• It is not certain that inflation is cooling. The US headline rate crept higher in July and August to 3.7% and oil prices had already risen sharply before the latest round of conflict between Hamas and Israel.
• This in turn prompted Federal Reserve chair Jerome Powell to assert that interest rates could stay higher for longer to ensure that inflation was beaten back toward the US central bank’s 2% target.
• US Federal debt continues to mushroom. Government borrowing has increased by $1.6 trillion since April’s debt deal, to take the total to $33 trillion. The rate of increase, fuelled by higher spending and sagging tax income, means that the US will need to sell more Treasuries to fund its debts. Worse, America needs to refinance around $15 to $17 trillion of its existing debt in the next two years. Worse still, the US Federal Reserve is no longer acting as the price-blind buyer of last resort, since it has ended its Quantitative Easing (QE) bond-buying scheme and started to run a Quantitative Tightening (QT) programme, whereby it does not reinvest the proceeds as bond holdings mature.

This is a painful combination. Any signs of these trends going into reverse could therefore put a lid on the benchmark ten-year yield, and, at some stage, investors will presumably decide yields have reach such a level that they are just too tempting to ignore, as they more than compensate for the evident risks on offer.

The colour of money

“The future trend in the US ten-year yield matters for three reasons, especially bearing in mind that the US ten-year yield bottomed at 0.51% in August 2020. Since then, the US ten-year bond index has fallen by 29% (since yields and prices have the same inverse relationship for bonds as they do for equities).”

The future trend in the US ten-year yield matters for three reasons, especially bearing in mind that the US ten-year yield bottomed at 0.51% in August 2020. Since then, the US ten-year bond index has fallen by 29% (since yields and prices have the same inverse relationship for bonds as they do for equities).

US ten-year Treasury price index has dropped by more than a quarter from its high

Source: Refinitiv data

• The US Federal Deposit Insurance Corporation (FDIC) reports that, as of the end of June, American banks are sitting on $311 billion on unrealised losses on held-to-maturity securities. The good news is accounting rules mean they no longer have to mark-to-market and book those losses each quarter. The bad news is that any unexpected run on deposits could force banks to liquidate to raise cash, thus crystallising those losses (rather as happened at Silicon Valley Bank in the spring). If the banks can hold the securities – which include a lot of US Treasuries – until maturity, then all may be well, but these potential losses are sitting in plain sight and so are the risks. The share prices of US banks are paying attention to the dangers.

US ten-year Treasury price index has dropped by more than a quarter from its high

Source: Refinitiv data

• The US ten-year is the risk-free rate against which returns from all other assets are judged. The US will not default, and it will pay the coupons. Any other investment must provide a higher return to compensate for the additional risks. The easiest way to get a higher return is to pay a lower price, so rising yields could yet weigh on valuations elsewhere (even if US equities are proving very resilient).
• America’s huge debts mean it cannot afford a sustained increase in their cost. The US government’s annualised interest bill is running at $1 trillion, when total tax income is only $5 trillion (and that is when the economy is doing well), while a modest slowdown in debt growth in 2007-09 resulted in near disaster. These numbers speak against rates staying higher for longer and a quick look at the history of the Fed Funds rate also suggests it is unlikely:

History suggests US interest rates will not stay higher for longer

Source: US Federal Reserve, Refinitiv data

“If history is any guide, the Fed will cut when the markets or the economy can take no more (as the American economist Rudi Dornbusch once argued, ‘None of the post-war expansions died of old age. They were all murdered in their beds by the US Federal Reserve.’)”

That suggests rates may come down quicker than markets currently think. It is tempting to view that as good for equities (as lower yields will reduce the relative attractions of cash and bonds). But perhaps we need to be careful what we wish for. If history is any guide, the Fed will cut when the markets or the economy can take no more (as the American economist Rudi Dornbusch once argued, “None of the post-war expansions died of old age. They were all murdered in their beds by the US Federal Reserve”). However, lower Fed rates did little to support falling share prices during the 2000-03 and 2007-09 bear markets as earnings downgrades outweighed and outpaced lower rates.

Past performance is not a guide to future performance and some investments need to be held for the long term.