One issue I’ve spent a lot of time discussing with people over the past few months is the recent increase in bond yields. In mid-September, the 10-year Treasury was yielding 3.61%. Despite (or because of) 100bp of Fed rate cuts, the yield on that same security is now up to 4.67%. Some market observers are assigning blame to the expected spending plans of President-Elect Trump. I’m skeptical of that conclusion. As I mentioned many times prior to the election, both Presidential candidates and both parties in Congress have a history of massive overspending and there are no plans to change that. I’m cheering for the new DOGE to cut spending, but am skeptical of their ability to do so. The main point here is that no matter who won the White House and control of Congress, until we’re ready to make meaningful cuts to both our military budget and our still-untouchable entitlement programs, the US is going to spend too much and print more dollars to fund it.
As the Fed cuts rates and Congress keeps adding stimulus, the bond market is projecting increased future inflation and demanding a higher return to hold dollar-denominated securities. I also think the primary reason for recent stock market weakness is expectations of higher future interest rates. This is an issue I’ve covered extensively here at DKI so why am I mentioning it again now?
The reason is because people tend to respond to round numbers as significant. It’s the reason retailers will price something at $9.99 instead of $10. The stock market often assigns significance to a 3% yield and a 5% yield on the 10-year Treasury. With a current yield of almost 4.7% and rising, it’s possible that we’ll see 5% soon. Should that happen, it’s likely the equity markets respond unfavorably.
I think Andrew Hart of Northern Trust summarized this point very well in this morning’s post. He writes:
RATES THOUGHT: If the market thought rates were done going higher there wouldn’t be $6 trillion sitting in money market funds. They’d be in 10 and 30 year bonds with their owners clipping coupons for years and years. The market doesn’t believe long maturity yields are beating inflation right now. No one believes real CPI is under 3%.
I agree with Andrew. People are sitting in cash rather than buying long-term bonds at an almost-5% yield precisely because they know the CPI isn’t accurate. As usual, we don’t see this as a problem; but rather, an opportunity. My personal portfolio remains heavily hedged with a lot of exposure that will benefit from more inflation.
Most of us here focus on the equity markets. It’s worthwhile to keep an eye on the bond market every now and then.
IR@DeepKnowledgeInvesting.com if you have any questions.
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