MICHAEL ZEUNER:
Hi everyone. This is Michael Zeuner, one of the managing partners at WE Family Offices. Thanks for listening to the Wealth Enterprise Briefing.
I’m joined today by Sam Sudame, a familiar voice to those of you who listen to our podcasts regularly. Sam is our Head of Global Macro, and he and I are going to have a conversation about what has been the big topic in the financial and general press in the last week or so: what’s happening in the bond market, specifically what’s happening to interest rates, and even more specifically, what’s happening to interest rates and prices of long-dated U.S. government debt.
We’re going to do a deep dive into why it may be happening and talk about what we think that means for investors.
So, Sam, welcome back. Thanks for joining. Let’s get started by giving us a picture of what actually has been going on. What’s all the noise about with respect to U.S. interest rates?
SAM SUDAME:
Sure. The market has really been focusing its attention on yields. Yields hit a nearly 20-year high last week, likely in reaction to the news that U.S. federal government debt hit the $40 trillion mark — and that’s with a T.
Just looking at the debt nominally, it took about 240 years to get to the $20 trillion level, and then we added another $20 trillion in just the past five years. We’re now at a debt-to-GDP level of about 100%, which is near World War II levels.
Especially last week, there have been a lot of stirrings in the Treasury bond market, particularly the 30-year part of it.
MICHAEL:
And what is the implication, Sam, as you see it, of all of that movement?
SAM:
What we’ve seen is the market paying attention to the intervention by the Treasury Department, and this is quite unusual.
The Treasury announced plans to increase purchases of long-dated bonds, signaling efforts to curb yields and ease mortgage costs. They’re planning on doubling their purchases of bonds to about $4 billion a week, focusing on the long end.
The Treasury has two ways of buying back bonds. I don’t want to get too much into the details of Fed or government operations, but the Treasury can buy back longer-dated bonds funded by shorter-dated issuance. However, we’re not seeing a duration or liquidity problem. So tinkering around with the yield curve might have a very short-term effect, but it’s doubtful it will be lasting.
Second, the Treasury signaled that it could use its general account to fund purchases of government bonds. The Treasury General Account is basically the government’s checking account, which is about $950 billion. So it appears to have a lot of firepower to buy bonds back.
But this account is used for short-term cash management. The Treasury targets a balance sufficient to cover five business days’ worth of expected net cash flows, including fiscal flows, debt maturities and a cushion. The U.S. government is gigantic, and this five-day amount is about $850 billion to $1 trillion.
As a result, there’s very little of the Treasury General Account that’s actually available to buy bonds. So it’s not the big bazooka to alter yields that the market might think.
I also think it’s very odd that the Treasury is wanting to buy bonds while Federal Reserve Chairman Warsh has long maintained his goal is for the Fed to sell its Treasury holdings.
And confusing the markets even more is that the Treasury’s interventionist approach to lower rates conflicts with the Fed’s more hawkish stance to control inflation. For example, yesterday the core PCE inflation report was meaningfully above the Fed’s target, and I think that increases the odds of a September rate hike.
So, in my opinion, the Treasury is sending out some pretty confusing messaging around rates.
MICHAEL:
Clearly, the impact is causing confusion in the marketplace. If we go back to where we started, all of that activity is actually having the opposite effect of what it’s purportedly intended to do, and it’s raising rates on top of the fact that the deficit is so large.
It’s raising long-term 30-year rates to the highest they’ve been in 20 years, which is not a good thing for bond investors because, as we all know, when rates go up, bond prices come down.
Are there other parts of the bond market, Sam, that may not be as directly affected by the government interventions and some of the confusing policy as the 30-year? Are there other places to be looking that might make more sense for an investor?
SAM:
Sure, but before we get to those areas in the bond market, I think it’s instructive to talk about yields in general because we’ve seen a lot of movement in yields this year.
Yields reflect the cost of money plus a risk premium for credit and inflation. The cost of money is largely driven by two things: the demand for money and the supply of money.
We’ve seen yields rise meaningfully this year, and we’ve mentioned it in several of our podcasts. But the largest driver of the increase is real yield, which reflects a much higher demand for money.
Due to the massive AI build-out — and I know we’ve had several webcasts on AI — there’s an extremely large demand for money needed for CapEx investment in the U.S.
Overseas, there’s also a lot of demand for money. Europe, for instance, needs trillions of euros for infrastructure and defense build-out. And the U.S. government, as we talked about at the very beginning, demands a lot of money since it runs deficits in the 5% to 6% of GDP range.
Another factor driving long-term yields is higher term premium, which reflects concerns about U.S. creditworthiness. This year, we haven’t seen that much of an increase in the 10-year term premium. But what we’ve seen, particularly recently, is that the 30-year term premium for Treasuries has increased a lot — perhaps somewhere in the 50- to 100-basis-point range.
The third thing that affects yields is inflation. But despite the conflict with Iran, increased inflation expectations — contrary to what most people think — have not been much of the reason for the yield increase this year.
The markets see higher energy prices as temporary. We see this in what’s called the term structure of inflation, which really hasn’t changed all that much.
Really, it’s going to be that demand for capital that keeps yields higher.
MICHAEL:
Okay. So you have, at the very long end of the curve, rates going up for the wrong reason. Maybe in the more intermediate end of the curve, you have rates going up for the right reason, which is economic growth and fundamental capital investment.
To me, that’s sort of a positive and a negative. The positive is there’s a lot of investment going on in the economy, there’s demand for capital, and that capital is yielding strong returns.
The negative is what’s happening at the long end of the curve, given signals about concerns around U.S. fiscal sustainability.
Before we leave that, let’s have a quick comment on what that means for the dollar. A lot of people have also been talking extensively about the dollar and what people are referring to as de-dollarization. How do all these factors connect to that as well?
SAM:
We’re seeing increased concern about U.S. fiscal dynamics. That not only feeds into yields, but it also feeds into worries about the U.S. dollar.
Even if U.S. yields rise, the dollar can weaken. Over the past month, the U.S. dollar has weakened quite significantly by over 250 basis points, and that’s related to worries about U.S. fiscal dynamics.
There are several different methods, like purchasing power parity and the real effective exchange rate, which show that the dollar is strong. But de-globalization trends can also lead to U.S. dollar depreciation as countries look to other currencies to facilitate international trade, although the dollar is still the dominant currency in international trade.
Higher geopolitical tension could also reduce foreign appetite to purchase U.S. assets and therefore lead to further weakening.
MICHAEL:
So you’ve got, on the one hand, this really strong real economy with significant capital spending, which is resulting in very strong earnings growth and driving equity prices up, which is a positive.
On the other hand, you have the intervention and fears about long-term U.S. fiscal sustainability and the fiscal deficit, which are driving the long end of the curve up. That’s not a good thing for investors.
So let’s end with one quick question: What’s an investor to do in this kind of context?
The one easy answer is stay short on duration. We’ve been talking about that for quite a long time. But if you think about these other trends — U.S. fiscal sustainability, de-dollarization and the 30-year public bond market sending a message of real concern — other than staying short on duration, what are some ideas investors can take advantage of?
SAM:
Especially with the de-dollarization that we talked about, gold tends to do well as the dollar weakens. In the past month, gold jumped a lot. It was up $700 an ounce just in the last month. It’s having one of its best four-week moves in the last 20 years.
In fact, gold is seen as an anti-dollar, so of course that tends to do well during de-dollarization.
Another direct way to do it is to invest in foreign-denominated financial assets, such as unhedged international bonds and stocks. We’ve seen the performance, particularly of non-U.S. equities, do really well last year and this year.
Foreign yields are also higher. As we mentioned, Europe needs a lot of capital. Japan is requiring a lot of capital. So those foreign yields look good.
And if the dollar weakens, that adds another return kicker to it.
MICHAEL:
To me, that all smacks of what we talk about over and over again, which is being sure that, as an investor, you have a diversified portfolio with bets spread across different markets, different currencies, different capitalization sizes and different geographies.
That’s always the right strategy, and particularly in a time like this.
So thank you, Sam. It was good to talk with you.
