Tough Love

Price discovery is a helluva thing. It’s also a normal thing. Or at least it used to be.

There’s no shortage of catastrophizing across the mainstream financial media around the most recent leg higher for long-end US Treasury yields (i.e., the August-September extension of what threatens to be a three-year selloff).

The hysteria is understandable to the extent it’s a function of the profit motive (hysteria sells) or if it emanates from journalists and editors too young to remember a time when fixed income was actually a market.

If some readers are inclined to suggest I’ve engaged in plenty of bond crash catastrophizing myself in recent years… well, guilty as charged. I’m afraid I can’t plead profit motive (the lights will stay on over here whether you read or don’t read). And, unfortunately, I can’t really plead youth either (I’m “young” in a relative sense but not so much in any absolute sense).

My defense is piqued interest. In August of 2019, I was nearly at a loss when it came to editorializing around fixed income. That summer, some euro high yield bonds sported negative yields, an oxymoron too stupid to be funny. At one point, there were 100 different issuers in the euro-denominated credit market whose entire curve was negative, prompting Howard Marks to wonder, “If having negative-yielding debt outstanding becomes a source of income, will levered companies be considered more creditworthy?” That sort of thing is demoralizing for a market documentarian, or at least it was for this one. I was losing interest in fixed income. It was a funhouse mirror, only without the “fun.”

We’ve come a long (long) way in four years, and my interest was resurrected accordingly. While I’ll be the first to concede that the rapidity of rate rise was surprising, the return of something that looks vaguely like normal in fixed income is actually comforting on some levels despite the accompanying losses for duration longs. Sure, the UK bond market had a seizure (exactly a year ago) and the US lost a handful of banks (R.I.P.), but considering how far yields rose, how fast and from what levels (i.e., from nothing or less than nothing), it’s a small miracle the system didn’t implode.

As I wrote a few days ago in “Much Ado About Price Discovery,” there’s nothing inherently nefarious about markets rationally assessing fair value for US Treasurys in consideration of macro factors, fiscal policy and the absence of a price-insensitive bid from the Fed. That’s what markets are supposed to do. A “market” where that’s not going on isn’t a market, which is to say a lot of younger “market participants” have never actually participated in a market.

But it’s not just late-twentysomethings, thirtysomethings and new journalism graduates expressing consternation. Even the biggest names in finance have taken to waxing semi-hysterical about 5% Treasury yields. Bill Ackman is the poster child, but Ray Dalio, Larry Fink, Jamie Dimon and a veritable who’s who of other brand names and titans have made similar (or related) remarks about the perils of a conjuncture in which US interest costs and debt levels are set to peak simultaneously for the first time in history.

The concerns are valid (or as valid as concerns about federal deficits in the US can be) as long as they’re centered around the fiscal and macro factors behind the repricing at the US long-end and not around the repricing itself. That seems self-evident, but the perceptive among you will notice that quite a bit of the commentary around the Treasury selloff reads like an accidental lament for the disappearance of the price-insensitive buyer.

“Beware the new Treasury buyers,” Bloomberg warned, bewailing the replacement of “steady-handed investors” like foreign governments, domestic banks and the Fed with ostensibly erratic, mercurial hedge funds, mutual funds, insurers and pensions, who “unlike their more price-agnostic predecessors [are] likely to demand a heavy premium to finance Washington’s spendthrift ways, especially with debt sales set to surge as deficits swell.”

The linked article cited JPMorgan’s Jay Barry. “It’s going to be a bumpy road finding that equilibrium in rates as these are more price-sensitive buyers,” he said, on the way to suggesting the end result will be a higher term premium and a steeper curve.

A trio of tailing auctions (the most recent three-, 10- and 30-year sales) only added to concerns. The long bond sale on October 12 garnered considerable attention.

“Such an occurrence is relatively rare, with just 11% of auction series since 2012 showing all three auctions tailing,” TD’s Gennadiy Goldberg and Molly McGown remarked. “With investor conviction remaining extremely low as the market is caught between still-firm domestic fundamentals and geopolitical risk, the 30-year auction appears to have further destabilized sentiment.”

Again, it’s not obvious that we should mourn market dynamics. “Older” investors spent years (a decade) insisting that the Fed and its counterparts were doing irreparable damage by suppressing price discovery and inhibiting the market’s capacity to transmit invaluable signals about fiscal policy and credit risk. Now here we are lamenting the reappearance of those signals.

It’s not a bad thing that the term premium is rising in the US. Nor is it a bad thing that a market (any market) is primarily comprised of price-sensitive investors. If everyone’s “price-agnostic” (as Bloomberg put it), then markets are meaningless.

The same goes for volatility. There’s palpable concern that a market where everyone cares about price (which is to say a market comprised of investors who want to be properly compensated for taking on risk) will be a more volatile market. Well, yes. And good, some might say. Not all volatility is bad. Indeed, the complete absence of volatility can sow the seeds for disaster.

The same Bloomberg piece noted that because Treasury yields “directly influence everything from mortgage rates to corporate borrowing costs,” the persistence of high yields and volatility in the US rates complex could be “bad news for a US economy already struggling to avoid tipping into a recession as soon as next year.”

Nobody wants a recession. But believe it or not, there are people who’d argue that it’s not the end of the world if corporates have to pay more to borrow, particularly given their habit of leveraging the balance sheet in order to buy back stock (i.e., saddling the company with debt, however cheap, for the sole purpose of enriching shareholders). And there are also those who believe that if the goal is affordable housing, financing costs shouldn’t be so low as to encourage bubbles.

I’m avowedly not an Invisible Hand acolyte. If I were a politician, I’d be a Progressive, with a capital “P.” Longtime readers can attest (emphatically) to both of those assertions. However, a lot of things are completely out of whack right now, for lack of a more academic way to describe the situation. It strikes me on some days that it might not be a terrible idea to let market forces impose a little tough love on everybody, from governments to corporates to consumers.

For those of you nodding your head vociferously in agreement, the rub is that you and I almost surely wouldn’t get along. My Invisible Hand days are few and far between.