Gift Horse or Trojan? The Unusual Leap in Long-Term US Treasury Rates
This one is going to be to the point, light(ish) on narratives and heavier on graphs than usual. I apologize in advance. Sometimes the heart is heavy, excess brain cycles have been expended, and there is little time to be cute.
Heart: Please give yourself a minute to check in with your own heart.
Brain: On where the excess brain cycles have been expended, read this.
Time: And now, let’s make good use of our time together.
Let me not bury the headline: September 2023 was a very unusual month in markets (October is equally unusual so far). Interest rates on government bonds jumped in an historic manner. If you’re a natural buyer of bonds, that’s good news. And if you think of investing in a more tactical manner, probably good news too. We should not de-emphasize that point. But, at the risk of looking a “gift horse in the mouth,” let’s look into why this move in US Treasuries happened. It seems like a healthy intellectual exercise, especially when the horse in question is the one horse that sets the tone for all the other horse races around town.
Refresher: US Treasury bonds are debt securities issued by the U.S. government to fund its operations, and they offer fixed interest payments over a specified period of time. When you buy a US Treasury bond, you’re lending to the US government and your prospective return is keyed off interest rates at the time of purchase. When you line up interest rates on US Treasury bonds according to their maturity dates, going from bonds that will mature in a few days to those that will mature in many years, you get what people call the “yield curve.” People talk about the “short end” of the yield curve (based on Treasury bills about to mature in a matter of days) and the “long end” of the curve (based on Treasury bonds that will mature decades into the future).
If you think about the flow of news and developments around the world, you would not be surprised if all the little things that happen daily impact the short end of the curve a whole lot while they impact the long end not very much. Most of the time, whatever “big thing” happens today will matter very little in a year’s time, let alone in twenty years. (October hasn’t been even remotely normal in terms of developments around world, but we’re talking about September here). Let’s call that the “Time Heals” or the “This Too Shall Pass” principle, borrowing the latter from my former boss Rob Arnott. As a result, the short end of the curve moves around a lot more than the long end. That’s how it’s supposed to work, and how it actually works nearly all the time. The recent past has not been not “normal.” There are reasons to think that it’s a big deal.
First Stop: The Yield Curve on US Treasuries
Let’s look at three separate snapshots: the end of September 2023 (the blue line in the graph below), the end of June 2023 (three months earlier – the orange line), and the end of September 2022 (a year prior – the green line).
You’ll remember that a year ago, interest rates were still relatively low, as the Fed was just getting started (as it turns out!) with raising rates. After a lot of that Fed hiking business, the yield curve moved from the green line to the orange line: the short end shot up, as one would predict, and basically nothing happened to the long end. So far, normal.
And then the darndest thing happened over the last few months: Long rates have jumped since June, while the short end of the curve has done its own version of nothing.
This is a big deal because:
Much of the big-time lending and borrowing in the economy is keyed off long-term interest rates like, you know, 30-year residential mortgages.
“We” (the Fed, on our behalf) get to move the short end of the curve mostly as we see fit, but the long end is controlled by the universe, not government technocrats. And the universe seems to be telling us that it’s not happy with us.
Long-dated bond prices react to yield changes much more sharply than short-dated bonds. If you own the bond and plan to hold it to maturity, that’s mostly irrelevant, but if you are required to do things like “mark your assets to market” – for regulatory reasons, like if you’re a bank – that’s not good. Banks go belly up over such things. As a temporary fix, the Fed created a “facility” in March after the SVB failure, where banks can turn in their bloodied bonds and pretend like none of this has happened. We are “socializing” the banks’ losses, as they say, to protect our banking system. Those losses just got worse.
Why is the Universe not Happy with Us?
Let’s address the main candidates.
Inflation: Higher inflation is bad for bonds, but that doesn’t explain September. There was no meaningful change in what people think inflation is going to be going forward in September. Basically, call it between 2% and 2.5%. That’s good, as the Fed can assume that we are taking them seriously. Team Fed: one point! (Note: That’s changed over the last two weeks. The inflation alert system just got upgraded in October, hitting 2.49% on Oct 19th 2023. War is the ultimate inflation machine, in addition to being the ultimate destruction machine. I refer you back to the heavy heart.).
Real Rate of Interest: The real (i.e., net of inflation) interest rate has jumped by an amount that can only be described as ridiculously large (technical term) over the last three months. This means that our collective guess as to what it’s going to take to keep inflation in check and not have the economic machine self-combust has taken a significant step up. Here is what this picture shows. Blue is nowhere near green and orange.
International Demand: The international demand for long-dated US bonds has just dropped, that’s a fact. China doesn’t like our Treasury bonds anymore (Most geopolitically tenuous gravy trains don’t last forever). Japanese investors used to buy our bonds, as did European investors. But now their own interest rates are high enough for them to be happy keeping their money at home. Lower international demand for our bonds means higher US rates. This is a two-sided kind of situation, though. It’s definitely bad for the US as a borrower nation. But… if you are a US investor looking to move money through time, you are not competing with China, Japan, and Europe like you used to. Yay for less competition! “Just kidding, kind of” (If you got that reference, you just made my day).
National Governance: Maybe the world is starting to think we’re turning into the types of people who don’t govern themselves very well. It doesn’t seem like an unreasonable concern. We can only hope that the next crisis (and it’s just arrived) will force us to snap out of our political malaise, and that our leaders – new and old – will rise up to the occasion. They say “hope is not a strategy,” but we should all hope that happens, for everyone’s sake.
How Big of a Deal Is This?
Look at the graph below, which plot all monthly changes in yields since 2000. The red dot is the “you are here” marker as of the end of September. The changes at the very long end (20- and 30-year maturities) are well outside of the norm.
By the way, when we look at the TIPS market (for inflation-protected Treasury bonds), the jump is just as abnormal: the moves to the right of the red dot were in the thick of the Great Financial Crisis (“The Good Ol’ Days” - Nobody Ever).
What does this mean? It means that the most important bond market in the world is under a lot of pressure. Again, this is good for people who want to buy bonds (i.e., people are starting to talk about “value” in bonds like they haven’t in long while). But it’s hard to see how this is good for the economy. Just to drive the point home, the 30-year mortgage rate is now around 8%, the number of new mortgage applications is at its lowest since 1995, and existing home sales back to where they were in 2010. In the meantime, a top player in best-in-class office buildings and malls is on the cusp of being considered “junk.” And a once-$4B Bezos-backed company is saying things like: “Following an exhaustive process, spanning many, many months during which we explored all viable strategic options for the business, the result is where we are today. Convoy is closing the doors on its current core business operations…”
These things are happening and it’s not clear that the rest of the market is getting the message. Yes, the S&P 500 was down 5% in September. That’s a real decline, but not the type of memorable repricing that’s just happened in the bond market. It seems like a good time to kick the tires on your investment risk profile, you know, just in case. Sometimes it’s good to think ahead.