To The Moon

In theory, yield curves are asymptotic: the longer the maturity, the higher the yield and with diminishing marginal increases. Upward sloping yield curves have two considerations imputed. The first is that bond investors anticipate a rise in rates. The second – also known as the liquidity spread – that longer maturities demand higher returns on account of capital remaining locked in for a longer period of time and the entailed risk.

Typically, long-term growth is more uncertain than near-term growth: there is more data about the near future and the events that impact the latter than the former. If long-term volatility is imputed, longer-term bonds have a higher yield imputed than in nearer-term bonds. On the other hand, there can also be a “negative liquidity premium” imputed; namely, the onset of a recession imputes a higher yield in near-term bonds than in longer-term bonds. This will be in effect even if the market expects rates to decline since investors would rather lock into longer-term bonds and “wait it out” rather than be invested in short-term instruments maturing into an uncertain environment.

The yield curve evolution of U.S. bond issuances across maturities in the Year Till Date (YTD) paints a fascinating (and yet familiar) picture:

Over the YTD, near-term bond yields have remained highly elevated, except for a brief period in the first month of Q2 wherein a picture of normalcy was nearly painted after the yield of 1-month bonds slipped below that of mid- and long-term bonds. In the period since and until the 26th of May (a Friday), yields of 1-month bonds had sky-rocketed to the highest levels seen in the year so far. Since then, while there has been a climb down, the steepness of the decline has pared off last week towards a gentler decline while still being significantly elevated above that of longer-term bonds. This affirms the market’s conviction that a recession is imminent (a conviction that has been expressed in most of the articles written in the year so far).

What’s telling, however, is that the mid-term bonds, i.e. those with 5- and 7-year maturities, should have a lower yield imputed than those of longer-term bonds. A peculiar form of curve inversion is apparent: while the 10-year bonds have the lowest yields of the whole pack, the 20- and 30-year bonds have a higher yield, with the 20-year leading over the 30-year and with both higher than the 5- and 7-year bonds.

So, market consensus could be summarized thus: the U.S. economy in a 20-year horizon is more uncertain than the 30-year horizon but is less uncertain in the 5- and 7-year horizons. Of the two, the 5-year horizon is more uncertain than the 7-year horizon. However, the U.S. economy is the least uncertain in the 10-year horizon.

Intuitively, this is a highly dysfunctional picture; economies cannot be expected to turn and reverse course on a dime in such a fashion. What’s apparent, however, in the current month is that both mid- and long-term bond yields are beginning to converge, most likely toward the 4.25-4.5 range. Combining this likely convergence with the fact that short-term issuances will likely continue to attract a high yield in the near future delivers a more meaningful outlook: bond investors seem to be of the consensus view that the likelihood of the U.S. remaining the world-leading economic engine is remote.

The shape of the yield curve is also influenced by supply and demand: for instance, if long-term bonds are in demand with not enough bonds available to meet the fixed liabilities of the likes of pension funds (who tend to be large-scale buyers), the yields on long-term bonds will trend low while prices rise. The low yield imputed on the 10-year bonds is likely due to it becoming an increasingly preferred choice for long-dated exposure over the 20- and 30-year bonds.

Overall volume and price trajectories in the iShares 20+ Year Treasury Bond ETF ( $iShares 20+ Year Treasury Bond ETF(TLT)$ ) – which hold the longer-term bonds – however, run counter to this phenomenon:

Meanwhile, the mid-term bonds – as represented by the iShares 7-10 Year Treasury Bond ETF ( $iShares 7-10 Year Treasury Bond ETF(IEF)$ ) – show a largely similar trajectory:

The drop in prices can be estimated to be a net function of the debt deal hammered out in the U.S. legislature: with the U.S. government being $31.4 trillion in debt and needing at least an estimated $9 trillion just to pay interest on this debt as rate hikes continue, it could be argued that greater fiscal discipline is an ever-increasing need of the hour and nearly impossible to put away while ongoing economic hardship by ordinary Americans necessitates high rates to rein in inflation.

The debt deal – that is now official – largely seems to ignore most of these needs while saving a paltry $1.5 trillion in savings over the course of a decade: military spending is increased by 3% to $886 billion, non-military spending stays flat until 2025, $60 billion (as opposed to $80 billion) remains allocated for U.S. tax authorities to expand enforcement and tax hike proposals for wealthy Americans earning more than $400,000 have been abandoned. Furthermore, both conventional as well as renewable energy sectors have received a boost: conventional energy permitting is expected to be eased while previously-made provisions for clean energy have emerged unscathed.

All in all, it’s more of the same. While rebel factions within the U.S. legislature made what is likely to be the stiffest opposition to the status quo, the debt deal indicates that this opposition was nowhere near enough to engender genuine reform in the legislature’s inertia. Along with rising costs of financing in order to prevent runaway inflation, there is also declining demand for this fresh new deluge of debt issuances as global asset managers diversify away from holding U.S. debt.

While the Treasury, the U.S. Federal Reserve itself and various governmental bodies can be expected to continue to buy into U.S. government debt, the downturns in volumes and prices shouldn’t imply necessarily that all demand for U.S. debt has vanished. For instance, Bank of America’s Flow Report from near the end of May indicated that its institutional clients have been modest sellers of stocks, with preferences for sitting out the volatility in equity markets in high-yielding cash & fixed income instruments.

Propelled by the “Treasury Stock Effect” – which implies that certain companies’ stocks are viewed as being more preferable on account of their ubiquity to the point that they’re grossly overvalued (and which was discussed in last week’s article) – the tech-heavy Nasdaq-100 ( $NASDAQ 100(NDX)$ or $Invesco QQQ Trust(QQQ)$ ) had outstripped the broad-market S&P 500 as well as both mid- and long-term bond ETFs in net performance in the YTD.

However, implying that overblown stock valuations are sustainable would likely be very tenuous: the bank estimates that "real rates" rising another 100-150 basis points would pop AI's ongoing "baby bubble" (and presumably collapse the valuation of the likes of $NVIDIA Corp(NVDA)$ and $Advanced Micro Devices(AMD)$ )

It will likely do well to watch for this bubble to pop and to see an “inversion” that will see bonds becoming more preferable. While the current administration is loathe to declare a recession as it prepares for the election next year, the fact remains that data strongly suggests that conditions similar to a recession in all but name will be manifested in markets, regardless of statements.

For investors interested in tactical plays on the turmoil in bond markets in the mid- to long-term maturities, a number of new Exchange-Traded Products (ETPs) give ample scope for leveraged performances for a very low fee and at affordable rates:

• $IEF5 gives 5X exposure on the upside to the 7-10 Year Treasury Bonds while $IE5S does the same on the downside.

• $TLT5 gives 5X exposure on the upside to the 20+ Year Treasury Bonds while $TL5S does the same on the downside.

For articles on broader economic events that are tangential to tactical market movements, visit asianomics.substack.com. The latest articles encapsulates my background research behind the commentary due to published in “Chosun Ilbo”, Korea’s newspaper of record while another article coming up this week will discuss key macroeconomic reports about the Indian economy.