Bond bombshell

0:00This episode is brought to you by bigdata.com. Your AI is only as smart as its data. Bigdata.com connects Claude, ChatGPT, and Copilot to the sources hedge funds and asset managers use. SEC filings, financial times, earnings calls, and over two and a half million transcripts from 50 plus countries. Verified institutional grade intelligence, right where you work. Try it free. Pay as you go plans start today at bigdata.com. Buckle up folks because the wheels are coming off in the government bond markets, and it is not pretty. As all good faithful listeners to this podcast know, bonds have been weakening for some time. And as they also know, this pushes borrowing costs higher and higher for all of us everywhere. Governments, companies, ordinary mortals like us getting loans and mortgages. Proof once again that if you think markets and real life are separate things, you are very much doing it wrong. Anyway, earlier this week, the drip, drip

1:01of sliding bond prices turned into a bit of a torrent. We had the biggest drop in US government bonds that we've had since Donald Trump's liberation day last year when he unleashed trade tariffs on the world. The 10 year yield or borrowing cost for the US government has now vaulted well above 5%. This is bad, okay? So today on the show, the bond bombshell and why it matters. This is unhedged, the markets and finance podcast from the financial times. I'm Katie Martin, a market's columnist, all locked in the bunker at FT Towers in London. Joining me in the studio, very unusually, in fact, for the first time ever, is the big fella Rob Armstrong. Hi Katie. Who let you in? I don't know. My old card from when I worked here seven years ago still works to get in the door. So, slid in unnoticed. No one will notice, don't worry. But also with me in the studio is Mr Ian Smith,

2:02one of the hardest working people at the FT, thrashing out markets news in our London headquarters. Ian, how are your nerves? I'm good and I'm glad you didn't call me the little fella. That's what I'm going to do. I thought you might have been working up to that. So it's okay. Look, I'm five foot two as far as I know. I said everyone's pretty big. Medium, I'm the medium fella. All right. Okay, first of all, chaps, let us gaze upon the destruction in bond markets. This has been a week and it's not even over yet. So, so far today, we're recording on Thursday, the US 10-year yield tickled 5.15%. Ooh. I got on a plane yesterday morning and yielded to a one place and I got off the plane and they were in a completely different place. Yeah. The yield moved inversely to your landing. Exactly. Exactly. Yeah. I mean, it was really, I mean, it was like a 14 basis point move yesterday and at one point they were 17 basis points

3:03and that, you know, those are hundreds of percent, which doesn't sound like a lot. Yeah. But in bond terms, that is big. Yeah. That is really an unusual day. I mean, in stock market terms, that would be like a day where markets moved like 7%. Yeah. Yeah. So yeah, like for normal people, 0.17 percentage points is like, meh, whatever, but holy moly, I have not seen a move that big in treasuries for a very long time. If you were on a household interest rate moved that much in a day, you would be quite scared. Yeah. Your mortgage would be significantly more expensive at the end of the day. That was at the beginning of the day. Yeah. No, likey. So look, for a bunch of reasons and God, you know, all of us here in this little grey studio, we talked to people in the bond market all the time, we said, ask them what the hell is going on. And everyone you speak to has got a different laundry list of reasons why they think bonds are weakening. So there is no right or wrong answer to this. But it's some sort of combination of fiscal incontinence, right?

4:03The US is just spending money. It doesn't have. It is borrowing a shed load of money. The more you borrow, the more your interest rate goes up, mix in a bit of inflation, mix in a bit of growth, mix in the fact that the Federal Reserve is raising rates, and you have a very, very bad picture for US government bonds. But it's almost like something sort of snapped at one point this week. Like Ian, where did it all really go wrong? You had this very strong PMI number, so business output growth in the US rising its fastest in five years. And that kind of fed into this sense that what you've got here driving this bond market sell off is a US economy that just won't stop. You've got this war in the Middle East that won't end. And you've got to your point governments and companies that just won't stop spending, right? And the bond market's responding to all of those things, but you saw this big move on this PMI number implying stronger growth into the future, higher interest rates. And that fed what has been a big repricing of US interest rate expectations that has driven this seller. One of the Fed governors went and opened their mouth.

5:05Oh, well, never do that. That added. Never do that. Yeah, this might take quite a few interest rate increases to get under control. So that was a little more fuel on the fire. And then at the same time, you had oil prices that were escalating again as some of the hopes that UN General Assembly would lead to a kind of brokering of some peace talks that didn't seem to happen. Did people think that was going to happen? Well, there had been a little bit of, you know, a rally before then as people maybe thought that. And then there was also a five year US government debt sale that didn't go particularly well that fed into those supply concerns. So all of this happened once, you know, the old toxic cocktail. There was one other. I think the olive in the cocktail actually, which is going to be a first ballot unanimous entrant into the bad idea hall of fame. The idea that we should ban exports of diesel from the United States. Oh, I literally love this idea. It's like, well, I mean, the idea that it's very hard for a lot of people who live in America when diesel is expensive, which is now.

6:08If you are a farmer, if you are a trucker, if you are a lot of different kinds of industrial businesses, the price of diesel is really starting to bite and closing the borders to diesel exports will bring that price down at first. But boy, will it increase inflation in the rest of the world? Inflation is not a phenomenon that stops at borders. It's just an unbelievably bad idea with clearly inflationary implications for everyone. And they're seriously talking about doing it. Yes, this does nonetheless seem to be a serious intention from Donald Trump, which is a puzzling move into the midterms. And yet it does feel a little bit like wetting your pants at the North Pole, right? Very briefly, you're all kind of warm and relieved and then you freeze to death. There will be, it will cause important inflation relief at first. Yes. And then it will have the opposite effect. And like the Treasury buy back operation, let's visit a little bit, it does speak to a little bit of desperation on the part of the US administration. We've lost control of some of the causes of inflation.

7:10So let's just try and deal with some of the effects in a way that might be counterproductive. If it doesn't kind of bring a lot of reassurance that they are dealing with one of the central problems, which is the rising oil prices that we've seen in the war. We have complicated this story quite a bit. And I think there is an aspect to it that is extremely simple. Roughly speaking, the 10-year bond yield travels with nominal US GDP growth. That is real growth plus inflation. Those two go up, bond yield go up. And right now, relative to those two things, bond yields are not that high. Yeah. nominal US GDP growth is it's 6 something percent. Bond yields are at 5. This is actually a yield double that makes perfect sense. So it's happening quickly. It's having unpleasant effects, but it's not surprising, per se, right? It is economically orderly in some sense that this is happening right now. The thing that a lot of people are talking about today is, no, sure, I can rationalize in my head that US nominal growth is here and inflation is here.

8:12So that means that the bond yields should be much higher. And it means that the Fed is raising interest rates. But the speed of that thing early this week, that's a thing. And what it suggests is that a lot of people in the market were caught on the wrong side of this. There were forced sellers. This sort of what markets nerd called price action. These sorts of really jerky moves on screens. They're like, not what you want. It is true. We talked about it at the start of the war with relation to European government bond markets, right? It's like where a similar thing happened, right? That market expectation that interest rates were going to go down in the UK, what's upended, guilt, sold off, more heavily than you would expect for the interest rate shift. And people suspected that maybe its hedge funds getting stopped out of positions, which is when a hedge fund is forced to exit a lost making position in government bonds or related derivatives. And that added to it as people had to dump those positions. It feels like we're seeing some of those effects come through that are magnifying the rises and yields. This is a very wise point from Ian Smith.

9:14We should get him on this podcast more often, Rob. He actually knows what he talks about. Actually, that may be the one wise point he's ever going to make. No. That's my question. That's my question. I'm out of here. The little guys on the move. What I like about it is it highlights something that's really important. Is that the implications of all of this for the US are going to be one thing and the implications for Europe. Well, I was about to say this whole thing is all fine and handy for the US, which has got really high growth. It's actually got pretty high inflation. It can grow and inflate its way out of at least part of this problem with much, much higher borrowing costs, which to be clear are painful. But these other things sort of mitigate the impacts. But because the Treasury's market, the US government bomb market is so much bigger than every other government bomb market on Earth. The result of what we're seeing in Treasuries at the moment is that it's pulling borrowing costs higher for everybody else. So thanks for that, USA. And that's coming after Japan has helped to push them up through what's going on in Japan.

10:15And we've seen in European government bomb markets as well. It's everyone's taking a turn to be the economy that kind of pushes up, longing for the bond yields. I think that's right. And from a general market's point of view. It's easier on a stock market to have high yields if growth is good. But for a stock market that's dealing with weak domestic growth, high yields are really poison. Right. And so that's the contrast for me between Europe and the US. So this is the thing. The UK and France, other countries with very high debt GDP levels. We can't just grow and inflate our way out of this problem in the way that the Americans can. So part of where the rubber is going to hit the road here is the UK hates higher borrowing costs. It really constrains political choices over where we can spend money. But the real one to watch, and I hesitate even to say it, is France, which wholly moly. Presidential elections coming up next year. No clear path to a sensible tax and spending stance today.

11:15So one of the things that's really worrying people is that the French 10-year government bond yield has stretched well ahead of Germany. So Germany is like the European safe asset. French yields are now more than a full percentage point above German yields. In Rob and I, at least, are old enough to have worked through the Eurozone debt crisis. And I do not wish to do this again. It was extremely unpleasant, extremely complicated. We are too tired. We're there to be another European debt crisis. So can you deal with it, please? Yeah, I will end the crisis now. Yeah, I mean, France is genuinely worrying. And if you look at French debt versus Italian debt, for example, it's now trading above as high a borrowing cost in Italy. And Italy is supposed to be the unfantile people of Europe, right? Like, obviously the most fiscally horrible country in the EU. No, the Italian for me there. In Fondé-Rieble. I don't know. I don't know. I was joking.

12:16I was joking. Yeah, no, I mean, it's a serious issue they have. They're trying to get their physical deficit under 5% of GDP. Lots of investors don't really believe the savings plan that they put as a lot of recently, their friends, sorry, to achieve that. Some of the kind of left-wing presidential hopefuls ahead of the election have been talking about debt cancellation as the thing. And the fact that that's even circulating, even if it's very unrealistic, is worrying people. They have direct service and costs of climbing. I suppose what you can say more positively is you don't see contagion from French government, those widening spreads, to the rest of the Eurozone. If that started to happen, I think people would think what's the role of the ECB here. At the moment, it's been a France is one of those more exposed indebted countries as a result of this war. And it's just for certain countries rising yields in themselves are very bad. And in the UK, though we're not in the same position as France, we have got a budget coming up. And there are possibly difficult decisions that they will have to take as a result of the rise in borrowing costs since the March

13:18public finance's forecast was made. And the positive way of spinning it is that the UK is undergoing a fiscal adjustment. And it's more can it keep that on track? Can it stick to the plan it's laid out? So UK and France are in the firing line here. And the higher borrowing costs are, especially in the UK, which I guess is the country we're most familiar with. It just means that the government is operating with one hand tied behind its back in terms of its options for what to do on taxing and spending. That is not to say that the US gets away with this scot free. Yes, it's got the growth. Yes, it's got the inflation. But already, famously, the US is spending more money on servicing its debts than it is on defence, which is bad. And all the kind of forecasts that Congress has put together over how much wiggle room the country has got and how much it's debt costs the country are predicated on yields that are much closer to 4% than 5%. So this is bad. It is bad. And the core response of the US to this problem for a long time

14:20has been to shorten the maturity of its debt stack. So instead of selling a lot of 10 and 20 year bonds, you sell more one year bonds, which does bring your interest to cost down a little bit. But those have to be refinanced. So if you shorten your maturity stack into a rising rate environment, you're just storing up trouble for the future. Yep, if you wish you a load of one year debt, then you have to keep issuing every damn year. And it just means that you're more sensitive to those short-term borrowing costs. Correct. Which are higher. So well done, you've painted yourself into a corner. Yeah, and we did store recently on that. You know, expected net issuance of treasury bills. So that's debt that matures in a year or less expected to reach around a trillion dollars over the coming year. But the more important thing to watch is the proportion of treasury bills in the overall US debt stock, which is, you know, on like Wall Street bank estimates in the coming couple of years, are expected to approach almost a quarter of the overall US debt. So that refinancing risk is growing. And there's really only two times in the past 20 years that it's gone above a quarter of the total debt stock.

15:22And that is COVID and the financial crisis. So the US is leaning very heavily on short-term debt to fund this kind of wide fiscal deficit. And that is storing up those financing risks that people are getting concerned about. And annoying people like us would note that when it was the Democrats that were shortening maturity on new debt issues, it was terrible. And the Republicans got very upset about it and now they're doing it. And it's fine. Do you mean Janet? I am the House Yellen. LAUGHTER I was the House. The Democrats sold the House. Who is the current House again? All right. It's got best of you. So Rob, just before we came down to record this podcast, we were in a badly mislabeled event online on the FT website called Ask the Experts, which I think the advertising standards agency should look into, Frank. Ask a pretend expert. My invite was lost in the post from that one. Ask a person. But people were asking questions about markets. And we were persons on the other end of it trying to answer them. The question that kept coming through over and over again,

16:24apart from will robots kill us all and will robots kill the stock market was, when do these higher borrowing costs? When does this nightmare in the bond market spill over into stock markets? And I didn't get to see all of your answers, but I answered all of them with, I don't know. LAUGHTER But like, this is a thing though, isn't it? It is a thing. I would say you can think about it one of two ways, or there's two channels for this to happen. Channel number one is, you raise rates to the point where you slow the economy, which is part of the reason that central banks raise rates. The economy is running too hot. Demand is outrunning supply. Yeah. So you... You hit the brakes. You hit the brakes on demand by increasing interest rates. That slows corporate profits. Stocks go down. Channel number two is, you raise rates so much that people are like, heck, I don't want to own stocks anymore. I'd rather own these bonds that are, you know, with a real yield of two or three percent.

17:24No risk. I'll take it. I don't think either of those things is happening very soon in the United States. Can I offer a potential channel number three? Which is, as we were just discussing, a lot of hedge funds are getting it in the neck on this move in rates. They didn't see it coming. They're on the wrong side of it. This is a good point. Bad things happen when markets move really fast. Accidents happen. Say a fund takes a big loss in one market. It might need to sell stuff that it's got in a whole completely unrelated market, different currency, different stock market, whatever, to keep the lights on. Everything is interconnected. And that's how these things can blow up in places that you're just not looking at. You raise rates until you have a financial crisis. The financial crisis causes a recession. And markets go down in recessions. That's so ruleful. Yeah. But the sharpness of the yield rise is really important. And in 2022, that's what got the UK and you've seen that in past financial crises. I suppose one thing you've said is that are you invoking the Liz Trust moment here?

18:26I'm simply saying that the rise and yield have been more telegraphed. I think you mean Liz the House Trust. Stop the house thing. You're good at competing with people. The bungalow. The prog's got the sheep. The house. The mini house. That went terribly wrong. For listeners who are hopelessly confused on this or who have not listened to previous podcasts, this all relates to the point where Scott Besson, US Treasury Secretary, was talking about the year in exchange rate which he's been seeking to control and saying, I am the house now, you can better against me if you like. And so because we're childish people, we're now referring to him as Scott Besson. And how are those bets going? They're going super badly. Thanks for asking it. No, the yen one is going okay. The intervention has come back a bit. This is a tangent. And I think Katie, you raised the correct point. The most immediate risk to markets from a rapid increase in interest rates is there's some horrible leverage somewhere. You don't know where it is as there is every time.

19:26You wake up one morning and somebody is bust. Yeah. You've never heard of them before, but you've definitely heard of the bank who lent them the money. And then, you know, it's party time. Yeah. So it's like the dynamite has gone off in the lake and we're just all waiting to see which fish rise to the surface. So that's an immediate risk. I don't think people are going to rush to the bond market because yields are higher. I don't think people are buying the dip here. They're too worried about the volatility. And I don't think the US economy is going to be slowed very soon by these rates because the AI boom is so price-insensitive. If a company is willing to eat a 50% price increase on its Nvidia GPUs, I don't think they're going to sweat on a 100 basis point increase in their interest cost for financing that data center. No, that's it. You got price kind of insensitive seller of that, right? Yeah. But listeners, here are us now. There's a bunch of things that can go wrong from here. And if we see another massive step higher in US borrowing costs.

20:27Yes, it's big. Take cover, tin hats on. We are going to come back in just one second with Long Short. A quick word from bigdata.com. Your AI tools are only as good as the data behind them. Bigdata.com plugs into Claude, chat GPT, and co-pilot via MCP, bringing in the sources serious investors trust. SEC filings, financial times, earnings calls, and 2.5 million plus transcripts across 50 plus countries. Institutional grade data right inside the tools you use every day. Start your free trial at bigdata.com. Okay, it is time for Long Short, that part of the show, where we go long, I think we love, or short, I think we hate. Rob Armstrong, very unusually, you were right last time. You were short, treasuries. Woo-hoo! I am long, things changing.

21:28My long, ignominious history of being wrong about everything came to an end at the end of last show, when I correctly said that yields were going to keep going up, and they immediately did as I said. Listen, this is a beautiful day. So I'm long, victory laps, self-congratulation, large egos. I love that. I'm sure people that say things will never change, so I would agree with you. Okay. Yeah, I just like, that's constantly something you face in markets, people that go on with, you know, based on my pre-existing knowledge and experience of the market, this is always how it's functioned. Yeah. And it's like, well, things can change in markets. And they certainly... I am long, the story this week from Bloomberg, have you seen this in the Morgan Stanley banker, who accidentally leaked an internal document listing more than a 100 investment banking deals, the firm is pitching. Are you so old-hearted? How can you be long, then? That is the coin-gear story. That's inviting some serious karma on yourself. I'm not, I'm not, you know, that's like making fun of someone else's direction.

22:30No, no. It's like, it's coming back at you. I'm long, this person from the point of view that I want to put an arm around them and buy them a beer, and say, you are having the worst week of your life. The long arm of Katie will go down for a second. Because you just like screwed up on one email at everyone I know who has seen this story has been like, they're but for the grace of God. Yeah, just want to say to them, have a great career outside of finance. Oh, God. Or just hang in there and it'll become the funny story, but it might take. Yeah, funny things happen. No, it makes your blood run cold. Listeners, including that banker or former banker, we will be back on Tuesday, so listen up then.