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The Return Of The Bond Vigilantes

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Authored by Doug Kass via Seabreeze Partners,

  • With mounting private and public debt, the U.S. economy is poorly positioned to reach consensus economic growth expectations

  • The Bond Vigilantes are saddled up and ready to make a comeback - and it's market unfriendly

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"I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody." 
- James Carville

In "The Great Bond Massacre" from late 1993 to late 1994, the yield on the US ten year note rose from 5.2% to 8.0% as investors grew fearful about the implications of large federal spending increases.

For the first time in years the bond vigilantes, "a self-appointed group of citizens - the bond vigilantes - who undertake law enforcement in their community without legal authority, typically because the legal agencies are thought to be inadequate" have surfaced - with the ten year U.S. note yield now approaching three percent.

This morning the yield on the ten year U.S. note has hit a new four year high of 2.99%.

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As I see, though rates still appear low by historic standards - the sizable climb in debt loads (in both the private and public sectors) and the continued fiscal profligacy - will likely exacerbate the impact on the recent rise in yields by providing a governor to economic growth and by stirring a number of other adverse outcomes:

Ballooning Deficits and A Large Supply of Treasuries Loom: A $1.2 trillion 2018 U.S. deficit (and borrowing requirement) coupled with $600 billion of the Fed's Quantitative Tightening means that there will be, according to David Stockman's most visual phrase, "the bond pits will be flooded with $1.8 trillion of 'homeless' government paper." Never in the history of modern finance has a near decade old domestic economic recovery faced a financing hurdle that represents almost nine percent of GDP. How large is this hurdle relative to history? At the top of the last U.S. economic expansion, the Federal Deficit was 87% lower (at $160 billion) - which represented only one percent of U.S. GDP at a time that the Fed was still buying Treasuries (in 2007 the Fed purchased $15 billion of Treasuries) and not selling them (or letting them rollover without replacing). So, this time around, the flow of Treasuries will represent supply that is nine times larger (relative to GDP) than was the case in 2007.

* Protectionism and The Chinese Debt Bomb Threaten The U.S. Treasury Markets: The Administration's assault on China and its trade policy threaten the demand/supply for U.S. treasuries, as the possibility that China sells down their U.S. Treasury holdings looms as a potential Chinese tool in the latest trade war with America. As well, the large stated and shadow debt in China when coupled with the capital flight issues suggest more selling of U.S. Treasuries is probable.

* The ECB Also is a Source of Treasury Supply: The ECB is also pivoting away from monetary ease in late 2018 and towards quantitative tightening in 2019. It's balance sheet of $5.5 trillion compares to only $1.5 trillion eleven years ago. This means the ECB, like the Bank of China, will not be soaking up anywhere the amount of Treasuries that it has in the past.

* Total Public Debt as a Percent of GDP is Near An All Time High: Back in 2007, when the debt load was well under $10 trillion, government debt service was about $350 billion/year. With debt of about $21 trillion today, a rise in interest rates could take debt service to nearly $1 trillion in the next 1-2 years. See, here.

Non Financial Corporate Debt is At an All Time High: See, here.

"Borrowed Prosperity": In looking at the last two charts (above) it should be clear that we are borrowing more to produce less output. In the last decade, credit market debt, at $69 trillion, has risen to 3.5x GDP, and has increased by almost $16 trillion. Unfortunately that $16 trillion has only produced about $5 trillion of GDP. In other words it is taking more and more debt to move the US economy:

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Bottom Line

Given rising private and public debt to levels never seen, an imminent pivot by global central bankers away from easing, the threat and possible consequences of trade policy and the poor demand/supply balance for Treasuries, among other factors - the return of The Bond Vigilantes will have an outsized and negative impact on the trajectory of domestic economic growth.

Despite protestations from the bullish cabal that interest rates are still low (by historic standards), the return of The Bond Vigilantes (who are now saddled up and ready for a comeback) is another threat to the decade old Bull Market in stocks.

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