Thanks Eliott, love your substack! There is also a lot of talk out there in terms of US treasury's (and some other places like British gilts)....are deficits going to finally matter to bond yields? Bond vigilante type talk. Will large supply's of treasury bonds at auctions in 2025 finally matter to yields? Or is the economy and inflation what really drive bond yields, and not supply of US treasuries?
Also there are the ever present debates about inflation going forward. Many pundits out there point to the large amounds of fiscal stimulus that will continue to drive inflation. As well as de-globalization.
I think those are all valid points. There's been an avalanche of Treasury issuance and that's likely to continue for some time regardless of who wins the election. In my view that means the long era of zero or near-zero rates is over, not just here in the US but also across much of the developed word. Also, I suspect elevated issuance means that rallies in bonds (especially long duration gov't bonds) will be weaker than we saw in the 2007-21 era and there will be some more powerful short-term sell-offs at times (spikes in yields).
However, I still think economic conditions and inflation will drive overall trends in bonds. For example, take a look at the US government bond auctions over the summer as the market grew increasingly concerned about a recession and (it appeared) inflation was on a steady glide path lower. We saw some very strong demand at auction, despite elevated issuance, and falling yields.
Over the past couple of months, the economic data has improved and the inflation picture looks a bit more hostile to rate cuts; we've seen a handful of auctions tail (basically yields spiked through the auction and the government had to pay a higher rate to borrow). There have also been a few examples of auctions where primary dealers have been stuck with a significant portion of the issue.
So, I think Treasury supply is an issue but when the market sniffs recession you'll still see rallies in bonds/declining yields.
I also wonder about the Fed in such an environment. The central bank will continue to say that it makes decisions based on economic/unemployment/inflation conditions, not based on what Treasury and the government want.
However, when you couple the Treasury's massive issuance with higher yields, the Treasury's debt service bill has exploded. That's a vicious circle as the government has to issue more just to pay interest on debt. I believe that puts some pressure on the Fed to cut rates when pure economic/inflation considerations might suggest that's not appropriate.
Along a similar vein, when Treasury issues bonds there needs to be a buyer on the other side of that trade. Increasingly, as the Fed issues new notes and bonds (rather than T-Bills) this has the effect of reducing bank reserves (as money in deposit accounts at US banks is used to buy bonds either directly or indirectly). Of course, falling bank reserves is an even more powerful headwind for the economy than higher short-term rates. And the relationship is non-linear -- when reserves drop below a certain, unknown threshold, credit conditions can tighten rapidly. I believe, in an extreme scenario where falling reserves start to bite, you could see the Fed restart QE in an effort to forestall a very nasty credit crunch.
As for inflation, all of these issues play into that outlook as well. What we saw in 2022-23 was the Fed tightened but the lagged effect of 2020-21 fiscal expansion (and brand new stimulus enacted in 2022) basically offset that tightening and the economy continued to grow. We also saw Treasury issuance of short-term bills soar in 2023-24 -- money market funds can buy T-Bills which (temporarily) minimized the impact of increased government borrowing on bank reserves.
So while inflation has come off its peak in terms of a year-over-year rate, it's still elevated and I believe the embers are still glowing. There's real risk we could see inflation remain elevated for years relative to the Fed's current 2% target in a 1970's-like environment.
Just remember that real economic growth in the 1970s (growth adjusted for inflation) was actually higher than the 1980's average and almost as high as the 1990s. The economy wasn't stagnant, the real problem was a boom-bust cycle and a ton of volatility in economic conditions, which filtered through into extreme volatility in financial assets like stocks and bonds as well as real assets like commodities.
Apologies for the long reply -- there are a lot of trends to unpack here. My main takeaway is that we're likely to continue to see more volatility in all of these markets. It'll be jarring for some investors accustomed to the rather placid rate environment of 2009-21.
However, the good news in all this is that rates/yields are much higher than they've been in years. And, periods like the 1980's when rates and inflation were much higher also represented a sort of Golden Age for more active management of bond portfolios. There are niches in the bond market than can perform well, offering strong yields and low volatility, when the economy is healthy and yields are rising. There are other niches to buy when the economy looks at risk of recession. Some segments are more sensitive to the Fed than others and some have more economic sensitivity. You can buy inflation protection in markets like TIPs that weren't available in the 1970s or 80s.
Generating strong real yields and total returns will be more a question of picking and adjusting your spots in the bond, credit and preferred stock markets given the existing yield, inflation and economic outlook.
Thanks Eliott, love your substack! There is also a lot of talk out there in terms of US treasury's (and some other places like British gilts)....are deficits going to finally matter to bond yields? Bond vigilante type talk. Will large supply's of treasury bonds at auctions in 2025 finally matter to yields? Or is the economy and inflation what really drive bond yields, and not supply of US treasuries?
Also there are the ever present debates about inflation going forward. Many pundits out there point to the large amounds of fiscal stimulus that will continue to drive inflation. As well as de-globalization.
Thanks for the kind comments about my Substack.
I think those are all valid points. There's been an avalanche of Treasury issuance and that's likely to continue for some time regardless of who wins the election. In my view that means the long era of zero or near-zero rates is over, not just here in the US but also across much of the developed word. Also, I suspect elevated issuance means that rallies in bonds (especially long duration gov't bonds) will be weaker than we saw in the 2007-21 era and there will be some more powerful short-term sell-offs at times (spikes in yields).
However, I still think economic conditions and inflation will drive overall trends in bonds. For example, take a look at the US government bond auctions over the summer as the market grew increasingly concerned about a recession and (it appeared) inflation was on a steady glide path lower. We saw some very strong demand at auction, despite elevated issuance, and falling yields.
Over the past couple of months, the economic data has improved and the inflation picture looks a bit more hostile to rate cuts; we've seen a handful of auctions tail (basically yields spiked through the auction and the government had to pay a higher rate to borrow). There have also been a few examples of auctions where primary dealers have been stuck with a significant portion of the issue.
So, I think Treasury supply is an issue but when the market sniffs recession you'll still see rallies in bonds/declining yields.
I also wonder about the Fed in such an environment. The central bank will continue to say that it makes decisions based on economic/unemployment/inflation conditions, not based on what Treasury and the government want.
However, when you couple the Treasury's massive issuance with higher yields, the Treasury's debt service bill has exploded. That's a vicious circle as the government has to issue more just to pay interest on debt. I believe that puts some pressure on the Fed to cut rates when pure economic/inflation considerations might suggest that's not appropriate.
Along a similar vein, when Treasury issues bonds there needs to be a buyer on the other side of that trade. Increasingly, as the Fed issues new notes and bonds (rather than T-Bills) this has the effect of reducing bank reserves (as money in deposit accounts at US banks is used to buy bonds either directly or indirectly). Of course, falling bank reserves is an even more powerful headwind for the economy than higher short-term rates. And the relationship is non-linear -- when reserves drop below a certain, unknown threshold, credit conditions can tighten rapidly. I believe, in an extreme scenario where falling reserves start to bite, you could see the Fed restart QE in an effort to forestall a very nasty credit crunch.
As for inflation, all of these issues play into that outlook as well. What we saw in 2022-23 was the Fed tightened but the lagged effect of 2020-21 fiscal expansion (and brand new stimulus enacted in 2022) basically offset that tightening and the economy continued to grow. We also saw Treasury issuance of short-term bills soar in 2023-24 -- money market funds can buy T-Bills which (temporarily) minimized the impact of increased government borrowing on bank reserves.
So while inflation has come off its peak in terms of a year-over-year rate, it's still elevated and I believe the embers are still glowing. There's real risk we could see inflation remain elevated for years relative to the Fed's current 2% target in a 1970's-like environment.
Just remember that real economic growth in the 1970s (growth adjusted for inflation) was actually higher than the 1980's average and almost as high as the 1990s. The economy wasn't stagnant, the real problem was a boom-bust cycle and a ton of volatility in economic conditions, which filtered through into extreme volatility in financial assets like stocks and bonds as well as real assets like commodities.
Apologies for the long reply -- there are a lot of trends to unpack here. My main takeaway is that we're likely to continue to see more volatility in all of these markets. It'll be jarring for some investors accustomed to the rather placid rate environment of 2009-21.
However, the good news in all this is that rates/yields are much higher than they've been in years. And, periods like the 1980's when rates and inflation were much higher also represented a sort of Golden Age for more active management of bond portfolios. There are niches in the bond market than can perform well, offering strong yields and low volatility, when the economy is healthy and yields are rising. There are other niches to buy when the economy looks at risk of recession. Some segments are more sensitive to the Fed than others and some have more economic sensitivity. You can buy inflation protection in markets like TIPs that weren't available in the 1970s or 80s.
Generating strong real yields and total returns will be more a question of picking and adjusting your spots in the bond, credit and preferred stock markets given the existing yield, inflation and economic outlook.
Thanks for the excellent & detailed reply! Read it and took notes!