 To get John Authers’ newsletter delivered directly to your inbox, sign up here. Today’s Points:
Atlantic CrossingCould a revolution in the US light the touch paper for an even bigger and more violent upheaval in France? There are precedents, and now it looks as though a financial revolt that started in America has lit a fire across the Atlantic. The dynamics of the global bond sell-off are growing a little clearer, although it has many moving parts. Yields rose in September, sparked by a sharp shift in expectations for the Federal Reserve. France was one of the worst affected. As October begins, that pattern is intensifying. The move to dump French bonds and replace them with German bunds was amplified Thursday, bringing the spread between the two perilously close to the record set during the euro zone’s sovereign debt crisis in 2011. Points of Return has run a version of the following chart several times of late; another update is needed:  The spark for the market’s crisis of confidence in French debt was lit in the US, for sure. But the spiral upward in OATS yields compared to bunds has now taken on a momentum of its own. The US is stepping back from its most hawkish forecasts for the Fed, at least for now - and yet French bond spreads surged ever closer to an all-time high:  So how did we get here? Let’s take the US and France in turn. Mistakes in the US Points of Return has dredged through the different explanations for the backup in yields often enough in recent weeks. But to start with one clear point, we need to distinguish between the secular trend and the sharp move since August. The secular trend in yields is upward across the developed world for solid and largely irreversible reasons such as the demographics of an aging population and the reversal of globalization. Just as Treasury yields enjoyed a steady downward trend for more than three decades until the pandemic, so it is reasonable to expect a long-term upward trend to continue for a while. That isn’t necessarily bad, and indeed there are advantages in tighter rationing of capital expenditures, and in offering savers a valid alternative to stocks after many years when governments essentially forced them to take a risk. But the process needs to be slow so that all the players can adjust. The speedy backup in yields we are now witnessing isn’t without danger. It’s hard to impute what’s happening to inflation, because the picture for price rises looks no worse, and arguably somewhat more reassuring, than it did before yields began to rise in earnest. Core PCE (Personal Consumption Expenditure) inflation remains at 3%, right at the top of the Fed’s zone of tolerance, according to August numbers released Wednesday. But this is driven by outliers. A core version derived from the trimmed mean - excluding extremes in both directions - continued to decline and is now at only 2.3%. There’s no great reason for fear in that:  It’s also hard to attribute this to any great loss of confidence in the US, whatever many foreigners think of President Donald Trump and his attempts to bully the Fed, because foreign holdings of Treasuries remain barely below their peak. The term premium - a measure of the extra compensation that investors demand over and above interest rate risk - has barely budged. What has happened instead is a big shift in expectations about monetary policy, driven largely by US officials’ communication mistakes. The 10-year yield stood at 4.6% when Fed Chair Kevin Warsh gave his disastrously received and intentionally vague press conference on July 29. Investors had penciled in a terminal rate for the Fed funds rate in this cycle of just over 4.0%. But why did Fed funds futures (as gauged by the Bloomberg World Interest Rate Probabilities function) price in another full percentage point of hikes from there? Treasury Secretary Scott Bessent’s interventions in the bond market might have had something to do with it. After promising to step up the Treasury’s bond purchases in August in an attempt to cap yields, he went on to say that there was a “fever” in the bond market. He also dared traders to bet against him, adding “I am the house now.” With the Treasury signaling so clearly that it was worried by higher yields, the supposition took hold that the Fed would need to hike overnight rates again. That might indeed be necessary, particularly if there is more bad news from the conflict in the Middle East. There’s no obvious reason to price in what hasn’t happened yet. Similarly, there was little obvious reason why markets suddenly brought down yields hard on Thursday - after quite positive ISM manufacturing data. A speech from the Fed’s deputy chair Philip Jefferson, stating the central bank might need more time to decide if another hike was necessary - an unambiguous message that the market was ahead of itself - came as the big correction was already well underway. In the course of the trading session, the futures market cut its estimate for Fed funds in October next year (a proxy for the terminal rate in this cycle) by 21 basis points. Fed expectations plainly led a steep decline in the 10-year yield, which dropped 12 basis points from peak to trough. All of this on an unremarkable news day:  So clumsy communication from the Fed and Treasury prompted a market overreaction that is now being messily corrected. None of this, to be clear, should change the overall prognosis that long yields will likely trend up over the years ahead. The speed of the move brought the risk of dislocations elsewhere, like in France. Much as a surprising hawkish shift from the Fed under Alan Greenspan in 1994 revealed underlying weaknesses in the Mexican financial system that led to the Tequila Crisis, so this Treasury scare has shone a light on where the world’s greatest vulnerabilities are to be found. That doesn’t mean that France must inevitably undergo anything as bad as the disaster that engulfed Mexico, but risks are elevated. What now in France? In the latest development, the government published the proposed budget for 2027. The main economic watchdog immediately said that its assumptions were “optimistic,” meaning that there was a risk of a further widening in the country’s deficit. The stakes are high as this is the last budget before next spring’s presidential election, in which candidates of the hard left and hard right appear to have a strong chance. The proposals aim to bring the French fiscal shortfall to 5% of GDP from 5.4% this year. Bloomberg estimates the total deficit reduction effort for next year at €54 billion ($61 billion). The response, despite the better news from the US, was a big rise in borrowing costs. Even as German bunds rallied, the yield on 10-year OATS rose to 4.92%. If it tops 5%, it will be the first time since 2002, when France’s finances and its politics were not in such disarray:  As France is part of the euro zone, any crisis must naturally extend to the rest of the currency area, at a time when most of its members are moving in a nationalist direction and likely reluctant to help. That is beginning to have an impact on stocks. The main European bourses sold off even as US equities rallied on Thursday. In combination with a weakening euro, the continent’s stocks have now given up almost all their gains since Trump took office:  What next? The history of the last 25 year suggests a) the European Central Bank will intervene to put a lid on yields - which may be politically easier if President Christine Lagarde, who is French, does indeed leave early, and b) that European politicians will find a way to muddle through. There will be plenty of opportunities for hedge funds and other traders to make money on the twists and turns ahead, but the likelihood is that this crisis will be resolved like the last - by kicking the can down the road. If there’s an added element, it’s political. The euro zone’s structure, with independent fiscal policy but a common currency, and a central bank that ultimately will do what it takes to keep the euro project alive, is evidently flawed. We’ve known that for a while. Until now, there has been no political appetite to find out what would happen if we just gave up on that model. Populist politicians aren’t necessarily bent on self-destruction, as the extremely pragmatic Giorgia Meloni has demonstrated in Italy. But the big risk is that voters in one euro-zone member or another decide to blow it all up. That’s arguably more likely in Germany than France, but in the medium term it is political decisions that could transform yet another example of painfully slow European growth into something worse. The spark for the crisis was lit in the US; European voters get to decide whether it detonates. Survival TipsThis has been written from Mexico City. One of the advantages of a passport is that you can go to great places. Some financially driven tourism advice: The peso-yen carry trade is obvious and painful, meaning you should probably postpone your Mexican holiday until the foreign-exchange market has come to its senses (particularly if you are Japanese). I advise Mexican readers to get on a plane to Tokyo while prices last. It’s another one of the world’s great cities, and in peso terms the souvenirs are going to be ridiculously cheap. A year ago I was in Tokyo and laughing at what a bargain everything was in pounds or dollars; now I’m gasping in horror every time I realize how much I’ve just had to spend. Have a great weekend everyone, and for a little mexicanidad to warm the soul, try this. More From Bloomberg Opinion:
Want more Bloomberg Opinion? OPIN. Or you can subscribe to our daily newsletter. Like Bloomberg’s Points of Return? Subscribe for unlimited access to trusted, data-based journalism in 120 countries around the world and gain expert analysis from exclusive daily newsletters like Markets Daily or Odd Lots. Follow Us
|
Comments
Post a Comment