Disruption and confusion in the Treasury markets driven by higher yields and Treasury interventions spooked investors and drove markets lower this week. If Treasury yields have risen because inflation expectations have risen, that’s bad. If Treasury yields have risen because of a decline in US creditworthiness, that’s bad. If Treasury yields have risen because of higher growth expectations for the economy, that’s good. But there may be more to the story. Which is why, this week, we need to explain why… yields are so high!
As investors of your hard-earned capital, we must calibrate our forecasting attention with your financial plan duration. Given the durations of educations, retirements, and lifespans, we focus our positioning further downfield as we create our investment outlooks. Fortunately, the longer the investment horizon, the more encouraging market history becomes, as the chart below illustrates:
Source: Creative Planning & Charlie Bilello
Stretch the time horizon, and the historical picture changes considerably. The S&P 500 produced positive total returns in 53% of one-day periods, 75% of one-year periods, and 89% of five-year periods. Over the 20- and 30-year periods measured, that figure reached 100%. This knowledge informs our asset allocations and our preference for holding rather than trading stocks. However, this doesn’t mean we don’t see short term oddities and opportunities, we just note them and check them against our risk assessments. After years of observation, my favorite short term directional indicators are the AAII Bullish Percentage and the VIX volatility index. When the AAII Bullish Percentage falls below 20 (80% of respondents expect declines), even a shred of good news can give markets reason to rally. Conversely, when the VIX nears 10 (extreme market complacency), a shred of bad news can spark a market pullback. At the end of last week, the VIX hit a year-to-date low, well under 15:
Source: Barchart
When the VIX plumbs lows, the search for a bogeyman begins. This week, that bogeyman appeared in the form of 30-year US Treasury Yields.
On Tuesday, the Treasury market hit a major milestone as total gross Treasury debt surpassed $40 trillion—the last trillion accumulated in just five months, a pace that, if sustained, could push the total to $50 trillion sometime before 2030. To be fair, the net debt (excluding money the government owes itself) only amounts to $32 trillion, but that total equals the size of the entire US economy. In response, the 30-year Treasury bond yield hit its highest level in nearly 10 years, well above the market’s prescribed 5% comfort level. This prompted Treasury Secretary Bessent to “intervene” by committing to buy more long-dated Treasuries by selling short-dated Treasuries to improve market function and cap rates. While the commitment amounts per operation are small ($4 billion), the initiation of a twist operation signals that the Treasury may have the willingness to do much more. I suspect they will have to.
Treasury Secretary Yellen did something similar that amounted to about $1 trillion of twist over a year compared with the $128b of run rate Bessent just proposed. If successful, the action could put downward pressure on longer-term rates, which could provide additional economic stimulus. If unsuccessful, it could raise questions about market confidence in the Treasury’s ability to manage the yield curve. The Treasury would then need the Fed to initiate quantitative easing by printing money to buy long-dated bonds. New Fed Chair Warsh has criticized previous Fed Chairs for the post-GFC balance sheet expansion and would have to eat lots of crow to join their ranks, making QE seem highly unlikely.
In sum, impromptu Treasury interventions and turmoil provided just the anxiety needed for correcting the overly complacent VIX. The VIX spiked 12% while the S&P 500 fell 2% on the news. Whether this satisfies the technical selloff required depends on the pathway for rates from here and the underlying reason for their ascent.
Inflation robs bond holders of yield and maturity value. Therefore, bond investors require additional yield in inflationary environments. While shorter term bonds correlate much more with shorter term inflation measures, longer term bonds correlate much more with longer term inflation expectations. For an assessment of current inflationary up-force on long-term yields we need to look at long-term inflation expectations:
According to breakeven inflation gauges, inflation will average 2.23% over the following five years and will average 2.20% over the next 30 years from today. Based upon these measures the Fed has not lost its inflation credibility. Therefore, it’s not inflation expectations alone pressing rates higher.
Investors more encouraged by growth prospects tend to buy fewer Treasuries as portfolio insurance. In fact, the combination of inflation expectations and growth expectations combine into nominal GDP expectations, which have the highest correlation with long-term interest rates as seen below:
Nominal GDP rates have recently risen back above 5%. From an equity-fundamental perspective, that can be positive, not negative, as corporate revenue has historically tended to move with nominal economic growth—even as higher interest rates can introduce offsetting risks. Higher nominal GDP supports higher revenues, earnings and… higher interest rates.
The US Treasury will issue somewhere north of $2 trillion in notes and bonds over the next 12 months. The buyer mix of foreign governments and domestic institutions fluctuates due to macro factors, as seen below:
Foreign Governments are the largest holders of US Treasuries and continue to be our largest buyers. Buying activity from institutional investors like insurance companies, pension funds and mutual funds now rank second as higher yields attract higher asset allocations. Third, we have central bank activity which shows a lower appetite for Treasuries, and may be one factor associated with the increased demand for gold. Then you have households and money market funds which have also increased their holdings as yields increase. Lastly, you have the domestic banks which need Treasuries for liquidity operations and to meet regulatory requirements. The point is the rise in Treasury ownership levels has largely come from discretionary asset allocators—pensions, mutual funds, money markets, and households. These buyers can choose from a menu of debt instruments rather than having policy or regulatory compulsions to just purchase more Treasuries. Enter AI. The supply of oncoming debt to finance the AI buildout could rival anything we’ve seen before. These bonds may increasingly compete for discretionary capital. Note the recent “crowding out” of Treasury ownership within bond funds:
And the supply of corporate debt coming to market is only accelerating. Note that while IPOs get the headlines, it's bond issuance that's truly surging into record territory as the chart below suggests:
In sum, the surge higher in yields reflects higher corporate bond issuance and higher nominal growth expectations. This stands to reason as “levering” up the economy should lead to “levering” up growth rates—and it has. The rise in Treasury yields may reflect some inflation fear and some lost confidence in US creditworthiness, but these are minor contributors. In my view, two forces are doing much of the heavy lifting: the rising amount of corporate leverage coming to market and the growth it may help stimulate. Until it doesn’t.
If you want to know where we are in the AI cycle, stop watching semiconductor stocks and start watching semiconductor bonds. Widening credit spreads may offer an early warning of weakness ahead for stocks. Treasuries might have grabbed attention this week, but they are only a symptom. AI Corporate bond issuance is the disease. For now, it’s a mild cough… but it bears close observation.
Have a great Sunday!
David
David S. Waddell, CFP® CEPA®
Chairman, Chief Investment Strategist
David Waddell is Chairman and Chief Investment Strategist at Coastal Bridge Advisors, where he chairs the firm's investment committee and helps guide portfolio strategy through macroeconomic analysis, market research, and risk assessment. With nearly three decades of experience, he is a nationally recognized commentator on economics and investing, with appearances on CNBC, Bloomberg, Fox Business, and Barron's. David is a CERTIFIED FINANCIAL PLANNER™ professional (CFP®) and a Certified Exit Planning Advisor (CEPA®). He holds a BA in Economics from The University of the South and an MBA in Finance and Investments from Babson College.
Sources: Yardeni Research, Bloomberg, Federal Reserve Bank of St. Louis, Opening Bell Daily, Barchart, Creative Planning & Charlie Bilello
This material is provided for informational and educational purposes only and is not intended to constitute investment advice or a recommendation to buy or sell any security. The information and opinions expressed are based on sources believed to be reliable, including third-party sources, but are not guaranteed as to accuracy or completeness. Third-party information has not been independently verified by CBA. Any forward-looking statements or hypothetical examples are for illustrative purposes only and are subject to change based on market and economic conditions. Past performance is not indicative of future results.