The Bear’s Lair: The revenge of the bond market

“I used to think if there was reincarnation, I wanted to come back as the President or the Pope or a 0.400 baseball hitter. But now I want to come back as the bond market. You can intimidate anybody,” said James Carville at the start of Bill Clinton’s Presidency in 1993. Since that time, the bond market has been in the position of an abused spouse, suffering endless humiliations at the hands of an inept Fed and Treasury Department. In the last few weeks however there have been signs that it was about to reassert itself. Should it do so, it would be immensely salutary – and immensely painful.

The yield on the 30-year Treasury bond is currently around 2.3%, up from a low of around 1.2% at the peak of the recession last spring. That is not a demanding level – the yield was above 3% as recently as October 2018. Nevertheless, in the context of a Fed policy that insists short-term rates will not rise from their current zero level until the end of 2023 or later, it implies a very steep “yield curve” indeed.

Normally, a steep yield curve is held to imply that the economy is expected to rebound strongly in the near future. Short-term money is cheap, because there is little demand for goods and services at present, but long-term money is more expensive, because demand is expected to pick up sharply and cause a surge in money demand in the future. That is the theory, anyway, though it dates back to the days of stable money and the Gold Standard and certainly has no predictive value when Gosplan is running the money supply as at present.

When Carville uttered his bon mot in 1993, the bond market seemed exceptionally strong because it had spent the preceding 15 years flexing its muscles. In late 1978 a “bond strike” had caused the Carter administration to tighten its fiscal policy considerably, then in mid-1979 the bond market caused a replacement of the Fed chairman, no less, with G. William Miller replaced by Paul Volcker.

Volcker, after a couple of months’ thought, perpetrated the “Saturday Night Massacre” of October, 1979, raising the Federal funds rate by 2% over a weekend, and then continuing to raise rates until inflation started to fall. The result was a massive rally in the bond market in spring 1980 (accompanied by a sharp fall in the gold price from its record level of $850 per ounce). Interestingly, the sharp bond market rally and fall in interest rates caused an economic recovery that almost brought the re-election of President Carter, but it also brought a resurgence of inflation that caused Volcker to raise the Federal funds rate to over 20% during the “lame duck” period when neither defeated President Carter nor incoming President Reagan really cared what he did.

The bond markets remained powerful through the 1980s. Bond market back-ups caused stock market swoons in 1982, 1984, 1987 and 1989, even though rates were generally trending downwards. The last evidence of a truly powerful bond market came in 1994, when Fed chairman Alan Greenspan pushed short-term rates back up from 3% to 6%, causing the bond market to crash, taking the British merchant bank S. G. Warburg with it (Warburg merged with a Swiss bank in early 1995). Barings’ crash in early 1995 can also be blamed on this market, though in its case it was a rogue trader fooling around in Japanese stock derivatives that caused bankruptcy.

Since 1995 however, the bond market has been a pussycat, and people have ceased fearing it. Interest rates have continued to decline generally, pushed not by a well-functioning market but by an artificial Fed monetary policy. For this reason, bond rates have never been a problem to this entire generation of bond traders (while continuing to churn out trading profits and thereby giant bonuses). Entire careers since the 1980s, leading to immensely cushioned retirements, have been built on leveraging to the hilt and holding a generally long position in long-maturity government or prime corporate bonds. Even cushier retirements have been built on the market for “junk” bonds, poor credit risks that are especially profitable and only rarely lead to more than partial default. Carville’s salutary fear of the market has vanished – after all, nobody trading professionally in the markets today has any experience of a bond market seizure, like that of 1978, and only a few remember the mild hiccup of 1994.

With the Fed providing ever-more monetary stimulus, the general expectation had been that the bond market would continue to be a pussycat, with yields rising and falling gently around an extremely low level (below zero in real terms). However, the extraordinarily irresponsible spending spree brought about by the last four Presidents and the COVID-19 epidemic may have changed this. The Federal budget deficit totaled $3.2 trillion in the year to September 2020 and is currently expected to total $2.3 trillion in the year to September 2021. Currently the projected deficit for the year to September 2022 is only $1.06 trillion, but that is without including anything for President Biden’s $1.9 trillion “stimulus” proposal, let alone any other goodies on the Democrats’ wish list.

With unemployment at only 6.5%, there is not much slack in the economy, so a $2.3 trillion deficit puts a real financing strain on the government bond market. The Fed is currently buying $80 billion of Treasuries per month, or $960 billion per annum, but that still leaves an additional $1.3 trillion that needs to be financed, around 6% of GDP. In other words, despite the Fed’s unprecedently sloppy monetary policy, successive administrations’ fiscal policy has now become so irresponsible that a 1970s situation of tight bond markets has been re-created.

A 1970s situation is likely to produce a 1970s result: a bond market crisis in which the Treasury cannot finance itself. It would seem highly unlikely that such a situation could occur while rates are so low but bear in mind: it is the rapid movement in rates, rather than their absolute level, that produces strains and crises. That is because the real driver of a refusal to finance the Treasury is a “strike” by investors and more particularly bond dealers, who refuse to take extra inventory on their books because it will only worsen their losses. Theoretically, Wall Street bond dealers should be neutral on the market; in practice they make much of their money by borrowing short-term and investing in long-term bonds, especially when the yield curve is “steep” as at present. (By doing so, they make currently 2% per annum on their entire portfolio, with very little apparent risk.) Hence, bond dealers’ structural “long” position will produce pain quickly if the bond market goes into a prolonged swoon, regardless of the level of rates. Pain, in turn, will produce a refusal by dealers to subscribe for new Treasury bond auctions.

Traditionally, a bond market “buyers’ strike” produced expressions of apology from the government and Congress, followed by a genuine and rapid attempt to reduce the budget deficit. In today’s world, however, the deficit is so huge and Congress and the administration so irresponsible, that no such action is likely. Instead, there will be huge pressure put on the Fed to accommodate the deficit and ease the bond market, perhaps by doubling bond purchases from $80 billion per month to $160 billion.

In the short-term, that might make the immediate crisis go away. In the long-term it will cause an even more determined upsurge in inflation. Just as in the late 1970s and early 1980s, there appeared to be no good answers to the twin problems of recession and inflation, so the recent period, in which both appeared to have been solved, will melt into the rearview mirror.

The bond market crisis then will become just one of many problems, the harbinger of doom rather than doom itself.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)