29/09/2023 “In the end, life is simple. Low rates push up asset prices.
Higher rates push asset prices down. We’re now in an era that will average higher rates than
we had for the last 10 years.” – Jeremy Grantham, 6 Sep 2023. Treasury yields spiked to new
cycle highs and European bond spreads have blown out. Yields have come off a bit as of this
morning, along with the US dollar and oil, allowing stocks to make some further clawback,
but the 10yr US Treasury note yield remains just a few bps off its highest in 16 years and
crude is not far from the $95 13-month high scaled yesterday. The UK 10yr gilt yield spiked
0.2% before retracing a chunk of the move – its move exacerbated by the recent decline in
yields as markets have been sharply revising peak rate expectations lower. Italian bond
yields rose more than peers as the government raised its fiscal deficit, seeing the spread
between BTPs and bunds widen to 200bps, the most since the March banking crisis. Across the
board yields are at, or very close, to levels not seen since the financial crisis (US) or
the sovereign debt crisis (Europe). And with expectations for what the Central Banks do next
reasonably well anchored – for now – it’s the long end that is proving interesting. Why
are long rates going up? A US government shutdown and possible US debt downgrade,
coupled with the ballooning budget deficit are factors. In Europe Italy and France are
signalling that budget deficits are rising – investors are starting to awaken to the fact
that they are going to be bigger for longer. This is something
we discussed back in April
after ECB governor Lagarde spoke about the fragmentation of the global economy. Italy said
the fiscal deficit for 2023 would be 5.3% of GDP, up from a forecast of 4.5% earlier this
year. 2024’s forecast deficit was raised to 4.3% of GDP from 3.7%. The deficit picture is
key. It’s not just perennial offender Italy; the US cannot get close to getting its deficit
down and everywhere in the West spending is rising. Inflation, surging migration and
spiralling healthcare costs are putting even more pressure on the budgets of European and US
governments. Bond vigilantes are back – higher structural deficits are a problem when the
Central Banks are not there to mop it up. Central Banks had kept the vigilantes quiet for
years but higher for longer has let them out. Huge issuance and Fed QT is something we
discussed before here – can the market absorb all that issuance just when the Fed steps out?
Basically it has – retail and institutions are buying the bonds that the Fed is not…but
demanding a much higher yield – they are far more discretionary than the automatic buying of
the Fed. It was never really about ‘who’ would buy the Treasuries but ‘what’ price they
would pay. We are finding out they want more bang for their buck. Indeed the Federal Reserve
Bank of New York’s gauge of the 10-year term premium became positive on Monday
(25/09/2023). It’s a sign that investors want more return for holding duration and points to
the long-end staying higher for longer. Japan is also a factor as it exits YCC – albeit
slowly – and is mechanically pushing up global bond yields. Investors are scrambling to be
on the right side of it when it does pull the trigger on exiting negative rates. And then
you chuck in the higher oil price just when inflation is supposed to be coming down –
suddenly everyone is worried that inflation will return with a vengeance. The key risk for
the market though is this: does weaker economic data bring down long-term rates, or do they
stay higher for longer and therefore a lot more restrictive for longer? Real rates are
exploding – it’s not about inflation so much anymore. 
Max Pain? But where is the pain trade?
Always look for max pain. Stocks have done way better than long bonds since the end of 2020
(see chart below), and this cannot last forever. 
Stocks are clearly overvalued, and investors are just
not getting adequate return for the risk – with cash rates where they are the equity risk
premium for US stocks is the worst in 22 years. 
Sources:
https://www.ft.com/content/b956c3cb-fd81-43a6-a0e3-3ebf4ec1bd8b?shareType=nongift
Neil
Wilson
Chief Market Analyst at Finalto
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