This is a report of our tour. When we began visiting clients, we were worried for the bond market. At the end of this tour, we are scared. The situation seems even worse than anticipated. In a nutshell, the bond vigilantes are back and the selloff can be far from over (in fact, it can be young). At this point, in our view, the most likely scenario is the following: the selloff will continue “until something breaks”. Nobody knows where the top in yields is, and we would not be surprised to see the 10y UST at 5.5% or 6%. We explain why in this note by reporting what we have heard from you.
P.S. It was a great pleasure meeting all of you in Turin, Milan, London, New York, and D.C. See you on Monday in Boston and Tuesday in Montreal (please, do not get offended if we circulate this report before ending the tour but next week is super busy). See you soon hopefully also in Brazil and China!
We proceed with the questions we asked to those of you (the “participants”) willing to share impressions, and we report the most significant answers. Our comment is at the end.
Why do you think the bond market is selling off?
Lots of factors. Most participants indicated a mix of causes, including: (i) the “for longer” message of the central banks (finally, markets are on board), (ii) the more dovish tilt of the central banks with the front-end, (iii) inflation forecasts which remain above target at the end of the medium-term, (iv) perceived higher R*, (v) perceived issue with “UST supply”, (vi) lack of fiscal discipline, (vii) stronger than expected economy.
Where do you see CPI inflation going forward?
Higher than target. Virtually all participants see a new regime in which, net of a recession, core/headline CPI average around 2.5% and core/headline PCE remain above target.
Is fiscal part of the problem?
In a nutshell, yes. Three participants mentioned explicitly that they are either “concerned” about “R” (the average interest rate in government debt) being already greater than “G” (the average growth rate of GDP), or that we might be at a “tipping point”. One participant mentioned “fiscal dominance” world. Several traders mentioned “UST supply issues”. Our understanding is that directly or indirectly more and more participants have started to worry about the lack of fiscal discipline and the size of the fiscal deficits.
What stops the selloff?
Something needs “to break”. Most participants perceive that the Fed is done hiking, therefore the monetary authority will not flatten the curve again. Everyone agrees that the fiscal authorities are completely absent. Most participants agree that we will not have enough evidence to conclude that inflation can return to 2% on a sustained basis (net of a recession) any time soon. Therefore, when asked “what stops the selloff?”, most participants replied “something needs to break or yields will continue higher”.
What would make you a bull?
It is very hard right now. For what we can tell, despite the attractive yields, only a few participants are thinking of taking a long position from here. The reasons are the ones listed above: (i) uncertainty around the inflation outlook, (ii) Fed “not committed enough”, (iii) lack of “fiscal discipline”, (iv) price action. One participant mentioned that yields look attractive for BTPs because “the country will be soon in a recession”. (see next para)
How far do you think a financial event can be?
Nobody knows. Financial events are non-linear events and they are hard to predict. Nobody seems sure of what can break and when. One participant mentioned that the price action of crude oil is consistent with a recession and that we could be “a few weeks” away from an event. Having said so, everyone is expecting an event at this point but again, nobody is sure of what/when. (FWIW, on this point, to us the September NFP report was not so strong as the headlines suggest – indeed to us the NSA MoM delta (chart here) continues to suggest a slowing economy).
Are risks well balanced around yields?
Risks are to the upside. Most participants report that risks are skewed to the upside for yields. For this reason, two participants said they expect yields to run on bad news (strong NPF, upside CPI surprises, etc..) but not necessarily to get lower on good news.
Our comment
Welcome back, bond vigilantes! Here is what we think it is happening. After the GFC, we spent 15 years at the ZLB/ELB. In that world, the word “bond vigilantes” did not exist because the fiscal authority could be as aggressive as it liked. In technical terms, we were in a “R lower than G” world. For 15 years, the Fed/ECB/treasuries have tried unsuccessfully to exit the ZLB/ELB. Then, Covid hit and we got the largest fiscal/monetary stimuli since WWII. Finally, we got out of the ZLB/ELB. The issue now is that the Treasuries pretend to keep doing what they did since 2008. The world above the ZLB is a better world with a non-depressed labor market. But it is not for free. This world requires a committed monetary authority and a committed fiscal authority. Without one of the two, we doubt yields can go lower from here.
As evidence, the reader can refer to Figure 1 and 2. Figure 1 shows the evolution of core inflation in the UK and in CH. Figure 2 shows the evolution of the gap between core cpi (UK minus CH) and the gap of the two primary fiscal balances (UK minus CH – the primary fiscal balance in CH is positive since 2022). Why Switzerland did not experience inflation? Sure, the Franc. And sure, it was less exposed to the natural gas shock. But a model has hard time explaining the gap only with the Franc and the gas shock. The model needs the demand side as well. Translated: a big victory of the fiscal theory. You want to make sure we go down to 2% from here? Then, do what it takes:a fiscal consolidation (in the US, UK, Italy, etc..). (Very directly: does it make any sense for the US to run the largest fiscal deficit ever (!) outside war and recession, given the status of the labor market? This is where we are. Some people refer to the US as “a success” but it is really not. Everyone can run the largest fiscal deficit ever..).
Figure 1. Core CPI in the UK and in Switzerland
Figure 2. Evolution of the UK – Switzerland “gaps”
Conclusion
To conclude. To us, the current economy/market is more similar to the mid-1980s than the ZLB/ELB. Policymakers should remember what are the rules in this new world. Until then, we suspect that yields will remain under a lot of pressure “until something breaks”. Yes, but what, when and where?