In the coming weeks we will likely hear James Carville’s name more often. Carville earned his fame as political adviser to the Democrats (his wife Mary Matalin was an equally famous Republican adviser), and is known for his pithy advice, having told the Clinton Democrats that ‘It’s the economy, stupid!’, and recently counselled them to ‘play dead’, whilst the Trump Republicans continue to make mistakes.
It might be expected that Carville will become sought after for his views on the forthcoming mid-terms, but it is more likely we will hear him quoted in relation to the bond market. In the context of mostly dull economists, journalists in need of a good bond market quote turn to Carville who stated that ‘’I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”
He said it in 1994, when US bond yields had pushed out to 8%, forcing Treasury Secretary Robert Rubin into a four-year deficit reduction programme – built on a rare moment of constructive bipartisanship – that halved bond yields and eventually produced a budget surplus. That kind of policy foresight, bipartisanship and political leadership is rare today; what endures is the bond market’s reputation as a powerful, intimidating beast.
Today, the bond market is back, and it is intimidating investors, governments and soon, the public. For all too long, bond buying by central banks had a soporific effect on bond prices, dulling them to the rising fiscal risks that have now enveloped most of the major economies. A couple of years ago we compared the effect of central bank liquidity to the storyline in the Danish film ‘Druk’ (which I recommend) where a group of teachers experiment with a permanent state of tipsiness. Central banks are now withdrawing liquidity, bond markets are sober and alive to the world and are pointing out various truths.
The first of these is that the ‘debt purgatory’ has commenced, precisely when the US Treasury Secretary made a series of failed interventions in currency and bond markets, demonstrating – in the spirit of Carville’s quote – that the bond market is more powerful than the government. In that respect, a threshold has been crossed where finance ministers may no longer be able to run near record deficits (in the context of economic expansion) and gargantuan debt levels. Scott Bessent, who has displayed a fetish for controlling market prices, may soon need either to start trimming spending, or to raise taxes (unlikely).
In France, the debate on the budget starts in earnest next week, in the context of the highest spread between French and German bond yields since 2012, and the woeful performance of the CAC 40 (in the past three years the Spanish and Italian stock markets have outperformed it by close to 90% and 75% respectively). To that end, debt, deficits and bond markets will dominate politics. For example, a recent Institute of International Finance (IIF) shows that the US spends more on interest payments (4% of GDP) than at any point in the last thirty years. In that context, it is likely that bond markets may only be calmed when governments make a serious effort to mend their finances, and when central banks enact further rate increases. This will prove to be a tough run into and beyond Christmas.
The second germane element of the rise in bond yields (which are only returning to their 150 year averages), is reflexivity, a word coined by George Soros to describe the ways in which moves in asset prices can cause effects in the real economy (and in other asset prices).
Higher bond yields should curb risk appetite and slow the economy. In previous economic cycles the thinking was that higher bond yields led to higher mortgage rates and thus a sluggish property market. The difference today is that many of the ‘Baby-Boomer’ generation have paid off their mortgages, or locked in mortgage rates at low levels, and the US middle-class has never been wealthier, and less rate sensitive (for example a new book ‘The Everywhere Millionaire’ by Owen Zidar and Eric Zwick traces the origins of the wealth of the 3 million Americans with over USD 25 million in wealth each and this effect is evident through the rest of the US wealth pyramid).
In other areas, the reflexive effect of bond yields may just be beginning and is already manifesting itself in the very riskier reaches of the corporate bond market (high yield/CCC rated bond yields are rising) and may soon take its toll on cyclical commodity prices (copper and oil).
The puzzle, optically at least, is that US equities have not registered the rise on bond yields. However, within the equity market, the many stocks have been weak over the past month (for example household ‘names’ Goldman Sachs and Boeing have fallen close to 20% since mid July) but headline indices have been kept higher by the small number of mega-cap AI related stocks (Intel, NVIDIA). Unlike US households who have in general been deleveraging, the AI complex is busy piling on debt. A sign of this is that UBS recently initiated a new publication, the ‘AI Debt Financing Monitor’. Experience tells me that the initiation of publications that herald the arrival of new asset classes is always a warning sign. To that end, the time to buy bonds is when yields rise to levels that brings hyperscaler debt raises to a halt.
Have a great week ahead, Mike
