The Bond Vigilantes Are Back

The following is an excerpt from our Morning Briefing of April 11, 2022.

There are two songs titled “Back in the Saddle.” One was the signature song of American cowboy entertainer Gene Autry, released in 1939. The other was released by American heavy metal band Aerosmith in 1976. Last year, the Bond Vigilantes were singing Autry’s soothing song. So far, this year, they’ve turned into the Wild Bunch singing the Aerosmith song.

What happened? And how much wilder will they be? Consider the following:

 (1) Delayed reaction to inflation. The CPI inflation rate rose from 2.6% y/y during March 2021 to 7.9% during February of this year. Over the same period, the 10-year US Treasury yield rose from 1.5% to 2.0% (Fig. 21). The bond yield was way behind the inflation curve over those 12 months. It was also well below the copper/gold price ratio, which implied that the yield should have been closer to 2.50% (Fig. 22). Since February of this year, the bond yield has caught up with the ratio but remains well behind the inflation curve.

(2) The Fed terminates QE4ever. With the benefit of hindsight, it’s clear that the Fed’s QE4ever purchases of $120 billion per month in the bond market contributed to keeping a lid on the bond yield last year. The program was terminated in March. The Minutes of the March 15-16 FOMC meeting were released last week on Wednesday, April 6. They suggested that the Fed’s balance sheet will be reduced by $95 billion per month starting in May. No wonder the bond yield finally rose to 2.50% last week! Next stop is likely to be 3.00%. If and when it gets there, we will assess the likelihood of the yield moving toward 3.50%-4.00%. Currently, that seems possible, but not likely.

(3) The end of the secular bull market? We may be seeing the end of the secular bull market in bonds. A decisive jump in the yield above 3.00% would certainly break the downtrend line in the yield chart since the mid-1980s (Fig. 23). More likely, in our opinion, is that the bond yield will base between 2.00% and 3.00% for the next several years.

(4) Compounding the deficit problem. Among the most unsettling issues in the financial markets is the impact of rising interest rates on the federal deficit. Net interest paid by the federal government totaled $382 billion over the 12 months through February (Fig. 24). That implies that the government paid an average interest rate of 1.6% on the $23.8 trillion in publicly held Treasuries during February. Here are the net interest costs at higher average interest rates: 2.0% ($476 billion), 3.0% ($713 billion), 4.0% ($951 billion), and 5.0% ($1,189 billion).

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