The Love-Hate Relationship of US Bonds – Swamponomics

On Treasury Island, US bonds have become the new gold. The yields on Treasurys have ballooned to levels unseen since the global financial crisis. The two-year and the 30-year options have crossed the critical 5% threshold, while the benchmark ten-year yield topped 5% before retreating to around 4.9%. But what has been driving the volatility in the US government debt market? It is complicated.

A Primer: US Bonds

The spike in Treasury yields has been influenced mainly by the Federal Reserve's quantitative tightening campaign, a blend of interest rate increases and trimming of the balance sheet. At the same time, other factors are at play: expectations of an economic slowdown, geopolitical uncertainty, worries about America's unsustainable fiscal path, and the federal government flooding capital markets with approximately $1.8 trillion in US bonds in the second half of 2023.

Mixed Demand

In recent weeks, investor demand has weakened considerably. Current Treasury auctions for two-, ten-, and 30-year US bonds produced abysmal results, forcing primary dealers (financial institutions) to scoop up double-digit percentages of Treasury securities. The lack of action among investors led to higher-than-expected yields. Of course, a higher yield causes greater borrowing costs for Washington and the broader national economy.

Households are beginning to take notice of the yields of US bonds. According to a new report from Goldman Sachs, American households and hedge funds are on track to purchase $1.3 trillion in Treasurys this year. As of the second quarter of 2023, the household share of bond net buying is 73% in the 2022-2023 span. By comparison, household representation of net selling was 16% in 2020 and 2021. When a retail investor can get a 5% or 6% guaranteed return, why bother stressing about stock volatility?

Foreign holdings of Treasury bills, bonds, and notes have steadily risen over the last year, growing by approximately $200 billion to $7.707 trillion. But China is the one major economy to dump US assets, trimming its ownership by about 15%, from $938.6 billion in August 2022 to $805.4 billion in August 2023.

Too Good to Be True?

While the nominal return has been incredible for mom-and-pop money market investors, the reality is that the real (inflation-adjusted) loss in the purchasing power of the US dollar decimates the profits. Simon White, Bloomberg macro strategist, ostensibly agrees. He wrote:

"The decline of the real dollar’s value when inflation is elevated is an additional kick in the shins to those holding Treasuries: what you’re paid back in is losing value in real terms too. Since the end of 2019, the dollar is down ~9% in real terms, compounding the 11% total loss in Treasuries over the same period.

“As the 1970s showed, the dollar’s real value is acutely exposed to elevated inflation, adding a sting in the tail for those already nursing losses in their Treasury positions."

Just Merger Arbitrage, Bro

But if you see an opportunity to earn some cash after enduring losses in a rising-rate climate, bond king Bill Gross recommends that the typical person should consider merger arbitrage instead. It might seem like a joke at first, but Gross spoke earnestly, arguing that there are no more money-making prospects in Treasury securities anymore. If you are wondering what merger arbitrage is, you are not the only one, as X (previously Twitter) users were baffled by the Bloomberg TV interview. But this is an investment strategy of profiting from successful mergers and takeovers. It is safe to say that the typical person does not have the time to comb through intricate market components, let alone study the mergers & acquisitions (M&A) arena. As financial analyst Geneve Roch-Decter recently quipped: “Become merger-arb expert overnight. Got it.”

Bad News for Washington

Higher deficits equal more bond sales. With the current administration forecasting $1 trillion in budget imbalances to be the new normal over the next decade, the financial markets will be drowning in Treasurys for the foreseeable future. As a result, investors will demand to be compensated more, meaning yields that potentially exceed 5%. This is horrific news for a government already dedicating about $1 trillion of annual spending to interest payments. Since Washington is unlikely to trim outlays by any meaningful amount, only one institution can bail it out: the Federal Reserve. But this is unlikely considering that the Eccles Building is reducing its balance sheet by offloading bond holdings.