Bringing the Pain to Treasury Markets

Bond investors are banking on higher for longer interest rates

For all the talk of rate cuts this year and how many of those cuts are being priced in by the stock market, the Treasury markets aren’t pricing in any. None. Zero.

Instead, we’re seeing just the opposite. The 10-year note has been on an absolute tear this month, jumping 40 basis points from 3.863% to 4.260% - a big increase for a single month, and February isn’t even done yet.

The 2-year has been ripping higher even faster, up 50 basis points from 4.194% to 4.690%. After the drop in yields that began in mid-October, what changed? Nothing — and that’s the problem.

Everyone thought something had to give — either the deficit spending lets up (and/or tax revenue rises) and debt issuance slows, or the Fed cuts rates, or foreign demand for Treasuries picks up, etc. None or the above.

The first three quarters of last year demonstrated that Treasury issuances were on a completely unsustainable path. But by the fourth quarter, people began ignoring the numbers, believing something was different about this Treasury market.

People often fall into the trap of thinking federal finance is somehow magical or different, but it must abide by the same rules of supply and demand that constrain everything else.

If the Treasury supplies debt in excess of demand for that debt, the market won’t clear. That’s an economist’s way of saying there aren’t enough buyers at the current price.

In most markets, excess supply will only be consumed by enticing more buyers with a lower price. In this case, however, talking about the government “supplying” Treasuries actually has the situation completely backwards.

In reality, what’s being supplied (and demanded) are loanable funds, or savings. We offer the Treasury the use of our savings for a price — and that’s the interest rate.

So, the flood of Treasury issuances isn’t a question of excess supply, but excess demand. Man-hands Janet Yellen is simply trying to borrow more than the market will supply at interest rates of 4%.

How do you entice more suppliers into a market? You have to offer a higher rate, and that’s what has been happening at Treasury auctions.

The nomenclature here is once again backwards from convention, so it’s worth parsing out really quick. When you normally think of an auction, people are bidding prices up, competing with one another to buy whatever is for sale.

But at a Treasury auction, people look like they’re bidding the price down, competing to lend money to the government, which wants to pay the lowest interest rate possible.

In reality, the Treasury is the one competing for people’s money - Yellen is vying against everything else you could be doing with your savings. If she doesn’t offer a good enough deal, there are no takers — or at least not enough.

That’s exactly where we’re at today with the 2- and 10- year Treasuries rocketing up this month to cover $140 billion of borrowing just since the end of January, along with hundreds of billions more in maturing debt that needs to be rolled over.

That’s why we just had what was without a doubt a very ugly auction for 20-year Treasuries. The 3.3 basis point tail was actually the largest ever for this maturity and dealers were forced to pick up more than a fifth of the auction, which is twice what they were stuck with back in November.

What’s the latest yield on the 20-year? 4.524%, which is up more than 30 basis points from the first of February. We’ve mentioned before that these higher rates are doubly problematic because of what you read just a few sentences ago: both new and old debt are now more expensive.

This year, the Treasury will issue about $2 trillion of new debt and roll over about $8 trillion of old debt. You’re talking $10 trillion of Treasuries at 4%+ interest rates issued this year.

A lot of the T-bills are already at today’s higher rates, so nothing changes there, but the notes and bonds that are maturing were at insanely low rates — we’re talking around 2% for a good amount of this debt.

Rolling that over at twice the rate doubles the cost of servicing that debt. Worse, Yellen is conducting the Treasury’s version of Operation Twist, or what some are calling yield curve control.

By issuing way more short-term debt and less long-term debt, it’s been keeping yields down on bonds and allowing bills to rise in order to pick up the slack. But that also means she’s making the interest on the debt go up even faster because she’s relying primarily on the most expensive debt instruments to carry most of the load.

But the sheer volume of debt is pushing Operation Twist Part Deux to its limits, as evidenced by the very ugly 20-year bond auction described earlier.

The shortage of loanable funds is kicking up rates everywhere because the Laws of Supply and Demand will not be conned. They are as immutable as gravity.

So, where do we go from here? Well, the Treasury is on track to borrow over $3 trillion this fiscal year (ends 9/30/24) and over $2.6 trillion this calendar year. Why the drop? It’s largely from the Treasury rebuilding its rainy-day fund, not an improvement in federal finance.

And those are optimistic scenarios, meaning no recession or further drop in tax revenues to exacerbate the deficit.

In other words, nothing’s changing, which brings us full circle to how we started this week’s newsletter: we’re on an unsustainable path, and bond markets are catching on.

Several economists had warned about this even before we did, but conventional media ignored them (and us). Now, the evidence is becoming so overwhelming that even the Congressional Budget Office agrees with us, at least in their short-term forecast.

Yellen will give all kinds of crazy excuses for why yields are marching higher, like saying it’s because the economy is “strong” — basically anything other than the real reason, which is that she won’t stop spending and borrowing money.

Why anyone still listens to the head cheerleader of Team Transitory is beyond us, yet here we are…

Whatever the case, it’s hard to see yields going anywhere but up, at least in the near term. Barring Powell really stomping on the gas and flooding liquidity to provide ample loanable funds, Yellen will be forced to pull in more money from the private market via higher yields.

The fact that so many institutional investors are keeping their powder dry says as much about the current stock market and real estate bubbles as it does about the trajectory of Treasury yields: bond investors see things getting worse before they get better.

That’s bad news for taxpayers who have to foot the bill for servicing the debt, but having some liquidity to throw at the auctioneer helps cushion the pain: it’s pretty easy to find CDs at 5% today.

But if you go CD shopping, don’t be surprised to find a banking sector that sees rates coming down, hard and fast — no one is offering longer maturity CDs at higher rates. In fact, most rates plummet by the time the maturity stretches beyond 1 year.

It turns out that the fixed income investments with the highest interest rates today are also the shortest maturities, which means you have greater flexibility too. A 60-month CD at 1.5% will be painful if higher for longer materializes as the bond market suggests it will.

If the bond vigilantes are truly getting ready to make their stand, then this would be one of those rare instances when low risk aligns with high reward.