The 10 Year US Treasury Bond Yield brushed 5%. This is the highest yield on that bond since July 2007. If bond yields remain at these elevated levels, this will be the third consecutive year of losses in that critical financial market.
As you can see from the table, three consecutive negative years hasn’t happened in living memory.
Last week, we shared a letter from PIMCO outlining their thinking for why bonds look primed for solid returns. This week we’d like to explore a couple of reasons why the bond market has been hemorrhaging these last few years.
Supply and Demand
Like any other market, the bond market reacts to supply and demand.
Since the first quarter of 2020, the US Federal Debt has increased by 43% ($10 Trillion) to $33 Trillion. That is an enormous amount of new bond issuance that had to get absorbed by the global investment community.
A majority of that new supply was purchased by global central banks in 2020 and 2021 but in 2022, these central banks began to unwind their balance sheet holdings which added to the glut of bonds for sale.
In addition to selling by central banks, commercial banks also began to sell bonds as deposit outflows accelerated. With Treasury Bill rates above 5%, holding excess cash at the bank didn’t seem reasonable. So, banks had to raise cash by selling bonds to fulfill withdrawals.
Most of the bond selling by banks in 2022 was offset by purchases from households, but their purchases have been cut in half this year.
Unfortunately, as demand for bonds has weakened, supply has continued to grow.
This year the US has had the third largest fiscal deficit ever. Crazy considering we don’t have a recession and unemployment is less than 4%.
The pace of issuance will grow significantly next year as well when combining refinancing maturing debts and new bond issuance.
Investors who are positive on bonds are effectively betting that a recession or some other negative shock will spur demand for bonds, thus rebalancing the bond market and alleviating the upward pressure on yields.
Return of Inflation
Over this period of surging bond supply, inflation has been persistently high. Fed Funds Interest Rates are now set near 5.5% in an attempt to combat inflation.
In June of 2022, the CPI growth rate peaked at nearly 9%. Since that time, it has fallen to the mid 3% range, but over the past three months it has begun to rise again.
Many economists and investors are predicting a 1970s style rebound in inflation.
They cite several reasons for their theory including:
- Reversal of globalization due to international conflict
- Limited availability of productive workers
- Under-investment in raw materials extraction (metals and energy)
- War in Ukraine and Israel
If they are correct and inflation does rebound above 5%, then bond investors will demand even higher yields to hold US Treasuries.
As you know, our base case if for recession but if we are wrong then bonds could continue to struggle under the weight of heavy new issuance and elevated inflation.
This is why we have significant investments in real assets and private credit. Both offer high yields and inflation protection.
