The Free-Money Experiment Is Over
Story by Ye Xie, Bloomberg, 10/9/23
Strategists at Bank of America Corp. recently got their hands on US bond market data going all the way back to the founding of the nation. And it shows, they say, that never before has there been an extended period of losses like the past three years.
It’s hard to know, of course, just how accurate the figures were from those early post-colonial years. (How often could bonds have traded during the War of 1812?) Still, there’s something jarring about a worst-in-236-years statistic. It’s a poignant reminder of the magnitude of the pain rippling through the financial world in the aftermath of an inflation shock and interest-rate surge that few saw coming. The pain was severe enough to take down Silicon Valley Bank and three other regional banks this year and pushed others into crisis until policymakers in Washington rushed to prop them up.
It also underscores the angst mounting rapidly in some corners of Wall Street about the increasingly shaky state of US government finances.
Massive deficits as far as the eye can see—the result, among other things, of the Republican tax breaks and the Democratic-led investment in green energy—seemed fine when the Federal Reserve had interest rates pinned at zero and was buying tens of billions of dollars’ worth of Treasuries every week. Free money can mask a lot of problems.
At today’s 5% rate, though, the math gets tricky. The government’s tab—and, as a result, the supply of bonds it needs to sell—adds up so fast that it can overwhelm what was long considered to be insatiable demand for the world’s safest investment.
“There’s just way too much debt,” says Ed Yardeni, a longtime Wall Street economist and founder of Yardeni Research Inc.
And so the price on the 10-year Treasury bond—a key benchmark for all sorts of borrowing costs in the economy—is tumbling, driving its yield up to the highest level in 16 years. Investors, in other words, are demanding a discount to buy the debt, a dynamic that’s magnified by the Fed’s sudden exit from the market. Quantitative easing, as the Fed’s bond-purchase program was known, became untenable once policymakers deemed inflation was Enemy No. 1; it just pumped too much cash into an already overheated economy. Central banks in Brazil, China, Japan, Saudi Arabia and elsewhere have also halted their US bond purchases. In some cases, they’ve taken to outright selling.
The vacuum created by the central banks’ departure is once again empowering the traditional forces in finance: banks, hedge funds, insurers. Yardeni likes to refer to this group as the bond vigilantes, a term he coined back in the 1980s. Right now, he says, they’re back to doing their thing, pushing bond prices down and yields up, and sending a warning to Washington to rein in the deficit and inflation.
This isn’t about the US defaulting on its debts. The periodic histrionics surrounding the debt ceiling and government funding deadlines are, for now at least, just that. The real concern is that by pursuing a fiscal policy that drives up yields so much, Washington is putting the squeeze on companies and consumers across America. Push yields too high, too fast and something in the economy will break.
It happened with SVB back in the winter. Yardeni frets it will happen again now—and potentially drag the economy into a painful recession in the process. “We’re getting pretty close to the level where something could break,” he says. A key level for him: 5% on the 10-year bond. Surpass that, he says, and the odds of a recession really pick up. The yield got as high as 4.89% last week. Just two months earlier, it was hovering around 4%. During the pandemic, it was as low as 0.3%.
The superlatives quantifying the bond rout are endless. One comparison being made is to the wipeout in stocks during the dot-com bust (in both cases, the losses reached almost 50%); another startling reference is that at one point last quarter the spike in yields was the biggest since the increase that proceeded the 1987 stock market crash. The pain has started to spill into stocks this time, too, albeit to a far lesser extent. Corporate bonds have also slid while the dollar has rallied against most other currencies. Even oil, which had largely been impervious to broader economic forces throughout the summer, got sucked into the bond market vortex last week, posting losses that broke a monthslong rally.
What makes this moment all the more shocking to Wall Street veterans is that it disrupted years of Fed-orchestrated stability in the bond market. That comatose state, in which benchmark yields hovered around 2% day after day, year after year, had become known as the new normal. The US—and much of the rest of the world—had entered an era of low growth and low inflation in the aftermath of the 2008 financial crisis, so rock-bottom rates made sense.
Few on Wall Street saw much that might change that, not even when the pandemic unleashed a torrent of government spending. Now that change is here at such a radical pace, many of finance’s best and brightest are suddenly citing all sorts of economic forces that could keep yields high for years: global warming, the transition to green energy, deglobalization, demographic shifts and, of course, the ever-growing supply of government bonds. “We are in a world with a permanently higher cost of capital, and that does have consequences,” says Torsten Slok, chief economist at private-equity giant Apollo Global Management.
The years from 2008 to 2020 were abnormal, even if at some point they came to feel normal, Slok says. The crew over at Bank of America dug up another historical nugget to underscore the point: Global interest rates during this period were the lowest in 5,000 years. “The new world that we live in,” Slok says, “is really the normal world that we were in.”
It’s a world in which Yardeni’s vigilantes, the bond traders, have a much bigger voice, the Fed has a smaller one, and consumers, corporate executives and Washington lawmakers have to confront a harsh reality: America’s free-money experiment is over.