The $24 Trillion Problem Haunting Wall Street
Story by Kevin T. Dugan, Intelligencer, 10/18/23
When Wall Street sizes up the world’s risks, one way traders make their bets on the future is through the market in U.S. Treasuries — that is, bonds representing the government’s debt. Since August, there has been no more critical story in finance than what amounts to a slow-motion crash of this $24 trillion market. Many longer-term bonds that were issued just a couple years ago are now trading for a mere of 50 percent of their face value. In stock-market equivalents, that kind of decline would rate as a full-scale collapse — and this is a category of asset that is regarded by most investors as very safe. On Tuesday, when a new report showed that U.S. consumers spent more on cars and restaurants than expected, some Treasury bonds sold off to their lowest level since 2006, levels that would have been nearly unthinkable not long ago.
That Treasuries have crashed during a time when the state of the U.S. economy has looked precarious is being read by many on Wall Street as a warning about both inflation and government spending. Some of the world’s most influential investors are talking in no less than cataclysmic terms about what the bond markets are saying. Their dire theory might be right or wrong, but there’s no question about one thing: The world’s largest financial market — usually a very boring and safe place — is suddenly chaotic and volatile, and nobody is sure why or what it means.,
The case being made by the bears is relatively simple. Hedge-fund icons like Bill Ackman and Ray Dalio have warned that the government has finally crossed a point of no return by borrowing too much for the world’s markets to handle, and that strain is starting to show. They point to what’s happening in the bond market as an indicator of a financial crisis on the horizon.
There’s no question the bond market is “deep into its extreme pessimism zone,” said Ed Clissold, the chief U.S. strategist for Ned Davis Research, an investment research firm, said in a research report. That much is clear. What economists and investors disagree about is what all this means and how big a problem it poses. Has the U.S. finally, after generations of scolding from fiscal conservatives (sounding a lot like Ackman and Dalio) that a reckoning was on the way, crossed over to having an unsustainable amount of debt? Or is there something else — perhaps less of an emergency — going on?,
In many ways the story of what’s happening in bond markets began with the bout of inflation that took hold in the United States last year. The consumer price index peaked at 9 percent after years of languishing under 2 percent. That inflationary spike spurred the Federal Reserve to hike rates at the fastest clip in four decades — and that, in turn, had massive implications for the Treasuries market (which, in a basic sense, is just the place where buyers and sellers figure out what interest rate government debt should pay).
But a strange thing has happened recently. After the Fed stopped raising interest rates, the yields on longer-dated U.S. government bonds — say, those that mature five years or more after issuance — kept rising higher. In bond markets, yields rise when bond prices fall, so the “crash” in prices of Treasuries in recent months has also showed up as a spike in yields. The ten-year Treasury bonds, the most important and widely held financial security in the world, jumped from 3.3 percent to a high of 4.8 percent yield during the last six months. In a market that tends to move in tiny increments, that’s a big move. The most important puzzle on Wall Street right now is why this spike has happened and what it means.,
The Ackman and Dalio camp points to high levels of government spending, a much larger national debt, and some follow-on effects in the bond market related to both those things. Because the federal government ran trillions in debt the past few years — blame COVID, the Inflation Reduction Act, and the hangover of Trump’s tax cuts — the overall quantity of U.S. Treasury bonds in circulation has gone up dramatically in recent years, hand in hand with the national debt. The heavy deficit spending of the past few years has been paid for by issuing trillions worth of bonds to investors. Today, the total Treasury market is just shy of $24 trillion, up from about $16 trillion in 2019. To a bond trader, though, that expansion is not just some abstract and unfathomably large number. It is supply.,
Ackman, in a tweet thread, recounted a meeting with a harried-looking investor who was distressed about that. “‘There are just too many bonds’ — a veritable tsunami of new issuance each week,” Ackman wrote on X. “I asked him what he was going to do about it. He said: ‘The only thing you can do is step away.’” Translation: Don’t buy bonds, they’re too dangerous to own because of the debt and supply situations.,
Not only are there more bonds for sale, there are fewer big buyers. Japan, formerly the largest foreign purchaser of U.S. Treasury debt, has cut down on buying Treasuries. China, another huge holder of American debt, has been a net seller lately. And the Fed, the largest holder of all, has not only stopped buying Treasuries, it has sold another $1 trillion of U.S. debt since last spring. No wonder the bond markets are headed for an unprecedented third straight year of losses.,
Dalio, the founder of giant hedge fund Bridgewater Associates and one of the most-watched investors on Wall Street, sees it as the early stages of disastrous spiral. “We’re going to have a debt crisis in this country,” said Ray Dalio, the founder of giant hedge fund Bridgewater Associates, during an investor conference. It’s a picture of a world flooded with too much of this debt, which is getting increasingly worthless, making bond traders less willing to buy it, and so on and so on. Meanwhile the increased cost of borrowing and debt service (that is, paying the higher yields on all those bonds) would eat up a larger and larger share of the federal budget.,
Debt crises are complicated things that can play out in various ways, but one thing that is safe to say is that they are very bad for bond holders (as well as for the governments that issue those bonds). Those in Dalio’s camp see no good way to get interest rates — and by extension bond yields — back down to where they were just a few years ago.,
This is creating a situation that has Wall Street looking back 40 years, well beyond the roughly microsecond-long average institutional memory in the financial industry. In the early 1980s, the bond market was just becoming a global force. But years of inflation had made bonds unprofitable — and investors hesitant to hold them, despite yields being in nosebleed territory. The markets were fearful that more government spending would cause prices (and yields) to rise again.,
Ed Yardeni, a prominent Wall Street economist who was then at the Fed, called those aggressive bond sellers “vigilantes” for trying to influence government policy. He’s predicting that those kinds of ruthless bond traders once again have the upper hand to punish a spendy federal government. “The consolidated deficit of the government, if you include the Treasury and the Fed, is — what can I say but huge. What we’re seeing here is the bond vigilantes protesting profligate fiscal policy,” he said. (To be fair, he has made this call a few times before).,
In the ’80s, things turned around — for a variety of complex reasons that economists still argue over — and bonds had a four-decade winning streak. But that winning streak now looks to have ended in the COVID-induced financial turbulence of early 2020, when the yield on the ten-year Treasury bottomed at less than one percent. Today’s bond bears would argue that what happened then shouldn’t be reason for optimism, since we are in a very different world now.,
These issues are technical, but they have major political implications and there are plenty of economists and investors who see a different picture than Ackman or Dalio or the other bond bears. “It’s really important to note that the repricing of Treasury yields is is far more predicated on changes to growth expectations and policy rates,” said Amar Reganti, who was a deputy director at the Treasury’s Office of Debt Management and is now an investment director and strategist for Hartford Funds, which manages more than $120 billion. It was as if, all of a sudden, economists and traders all over the world woke up to find that they’d gotten everything wrong, and all hit “sell” at the same time. These kind of sell-offs “tend to be violent, because it’s the losses that often drive flows,” he said. But it’s not a debt crisis.,
To be clear, nobody’s saying that there aren’t real reasons to think that supply isn’t a problem — just that it’s not the main one. Reganti said that, if there were too many bonds, he would expect to see problems in other markets, like short-term repurchase agreements, but that just isn’t happening. “The Fed is seen, rightly or wrongly, as having gotten things under control,” Nathan Tankus, research director at the progressive Modern Money Network, said.,
During the years after the 2008 financial crisis, a common refrain from Wall Street was “don’t fight the Fed” — meaning that, for as long as the central bank kept buying bonds and holding rates near zero, bond traders (and the rest of the U.S. economy) should count on being able to borrow cheaply. Lately, however, Wall Street has been doing a lot of bickering with the central bank. Jerome Powell, the Fed’s chair, has been trying to tell the public that he is going to keep interest rates higher for longer than pretty much anyone would have expected until this year. This has caught even the most sophisticated bond traders off-guard — and been an important factor in the larger bear market in Treasuries.,
Wall Street is now betting that Powell will stick with higher rates for longer. Meanwhile, Washington’s debt spending and the resulting bond supply isn’t shrinking any time soon. Today’s bears have been making tons of money dumping bonds into the broader markets. But being a vigilante means holding a hostage and making demands. At this point, it’s not clear what kind of leverage they really have over the markets, and whether the Fed would even be willing to cave.