The recent week has marked a tumultuous period in U.S. politics and finance, culminating in a crisis that saw the temporary lifting of a government shutdown, albeit at the cost of ousting one of the highest-ranking officials in American politics, House Speaker Kevin McCarthyAdditionally, the Federal Reserve has reported staggering financial losses that have resurfaced questions regarding its operationsThese events are intricately tied to a storm brewing in the U.STreasury market that has captured the attention of global financial markets.

Currently, U.STreasury bonds are experiencing the largest "bear market" in history.

As the "anchor" for global asset pricing, the yields on 10-year Treasury bonds have reached levels not seen in 16 years, climbing to a peak of 4.89%. Compared to the peak in March 2020, the price of 10-year Treasury bonds has plummeted by 46%, an equivalent decline to the 49% drop experienced by the U.S. stock market following the bursting of the Dot-Com bubble in 2000.

Moreover, the 30-year Treasury bond has dramatically decreased in value by 53%, closely paralleling the 57% plunge seen during the financial crisis.

Kevin McCarthy has become the first victim of this Treasury storm, but he certainly won't be the last.

On October 3rd, the House of Representatives voted to remove McCarthy from his position with a slim margin of 216 votes to 210. This historic decision makes him the first Speaker of the House to be ousted in U.S. history.

In just nine months, McCarthy's tenure as Speaker has seen both his ascendance and demise be marked by historic events.

The crisis that ultimately led to McCarthy's ouster stemmed from yet another impending government shutdown

Advertisements

This crisis arose merely three months after the previous threat of a shutdown.

Hours before the impending government shutdown on September 30th, McCarthy chose to compromise with Democrats, passing a temporary funding bill to keep the federal government operationalHowever, this bill did not meet the demands of the House Republicans' hardliners, who had sought deep cuts to federal spending and increased border controls.

On October 2nd, Representative Matt Gaetz initiated a motion to oust McCarthy, citing his failure to adhere to the hardliners' demands.

The temporary funding bill, which McCarthy successfully shepherded through Congress, provides funding for the federal government to continue operations until November 17thIf Congress does not pass new funding legislation, the government will begin to partially shut down on November 18th.

The reasons behind McCarthy's removal, while entangled in party politics, are fundamentally rooted in the issues surrounding U.S. debt.

As it stands, the U.S. government cannot function without issuing debtAccording to data from the Treasury Department, U.S. national debt surpassed $33 trillion for the first time in September this year, marking yet another record high—only three months after crossing the $32 trillion threshold in June.

This figure signifies that over the past three months, U.S. national debt has increased by an additional trillion dollars.

Meanwhile, the Federal Reserve is currently undergoing a historic cycle of interest rate increases and balance sheet reductions. Without the Fed acting as a significant buyer, the burden of this massive issuance falls upon the market, resulting in tight liquidity in the Treasury market and soaring bond yields, necessitating the U.S. government to issue debt at elevated interest rates.

The non-partisan research organization, the Committee for a Responsible Federal Budget, stated, "The U.S. has reached a milestone that no one should be proud of, as our national debt has just exceeded $33 trillion

Advertisements

We are becoming increasingly numb to these staggering figures, but that does not diminish their danger."

U.STreasury bonds are generally regarded as a standard “risk-free asset”, with their prices serving as a reference point for asset pricing globallyIn other words, the value of stocks and other securities is often assessed relative to Treasury yields.

Yet, with the recent violent fluctuations in Treasury prices, global markets have begun to tremble.

On October 6th, the U.SBureau of Labor Statistics released new employment data, showing that 336,000 non-farm jobs were added in September, far exceeding the expected 170,000. The previous months of July and August also saw upward adjustments totaling 119,000, with 236,000 and 227,000 respectively.

This stronger-than-expected job growth amplified expectations of further interest rate hikes by the Fed, leading to a sharp decline in Treasury prices and an increase in yields. The yields on 30-year Treasury bonds momentarily surpassed 5%, while 10-year yields approached 4.9%, marking the highest rates since 2007 and reflecting an increase of over 40% compared to rates earlier this year, which were at 3.40% and 3.52%.

The largest long-term bond fund in the U.S., the iShares 20+ Year Treasury Bond ETF, has seen a 48% decrease from its historic high in 2020, effectively halving in valueIn terms of annual performance, this ETF has fallen about 10% within the year and has dropped an alarming 33% the prior year.

The surge in yields has had another consequence: the U.S. dollar has rebounded

Advertisements

Since mid-July, as Treasury yields have risen rapidly, the dollar has strengthened against major currencies, averaging a 7% rise against G10 currencies. Currently, the U.S. dollar index is nearing a 10-month high, which measures the dollar's strength against six major currencies.

The spillover effects of the soaring Treasury yields are inevitably permeating through the global bond market.

On October 4th, the UK’s 30-year gilt yield reached 5.1%, the highest level since September 1998.

Germany, typically regarded as a safe haven, has seen its 10-year bond yields surge to 3%, returning to levels last seen during the 2011 Eurozone crisis.

In Japan, the 10-year yield has notably surpassed the 1% mark for the first time in years, signaling a change from the ultra-low rates maintained historically.

Australia is also experiencing a dual assault in equities and bonds, with the drop in 10-year yields surpassing that of U.STreasuries.

For the U.S., the soaring Treasury yields translate into significant pain across various sectors, including stock markets, banking, and real estate.

Since September, all three major indexes for U.S. stocks have experienced substantial declines

The Dow Jones has fallen by 3.79%, the S&P 500 has declined by 4.42%, and the Nasdaq has dropped by 4.3%. On October 5th, filings to the SEC revealed that Apple CEO Tim Cook sold off approximately $41 million in stock, marking his largest sale in over two years, reflecting his pessimism regarding Apple’s future stock performance.

Heightened interest rates pose a significant burden on corporations as well, with companies that can only issue debt in high-yield markets facing dramatically increased borrowing costs. According to the Fed’s economic data, the ratio of corporate debt to GDP has surged to historical heights following the leniency in loan provisions during the early pandemic. This indicates that corporations will now contend with refinancing at dramatically higher interest rates, forcing them to cut spending and investment.

As bond yields and mortgage rates climb, the housing industry feels the strain significantlyThe rate for a typical 30-year fixed-rate mortgage, the most popular home loan in the U.S., has surged to its highest level since 2000.

Peter Boockvar, Chief Investment Officer of Bleakley Financial Group, highlights, "For anyone facing debt maturity, this is a rate shockFor real estate professionals with any adjustable rate loans maturing, it’s incredibly difficult."

The rise in rates has also put pressure on regional banks holding declining-value bonds, contributing to the downfall of institutions like Silicon Valley Bank and First Republic Bank

While analysts predict no further bank failures, the industry has been actively seeking to sell assets and tighten lending.

Today’s financial conditions are even tighter than previously observedThe banking sector currently benefits from the Fed's Bank Term Funding Program (BTFP), which creates a safety net; hence, the immediate risks are mitigated, but this mechanism will end in six months. The negative implications of high interest rates on financial markets may further escalate.

Lindsay Rosner, Head of Cross-Asset Investment at Goldman Sachs, warns, "Our yields are now 100 basis points higher than they were in MarchIf banks haven’t solved their issues since then, the problems will only escalate as rates continue to increase."

Since the Fed began tightening monetary policy last year, two significant financial upheavals have occurred: the "UK bond crisis" in September 2022 and the "U.S. regional banking crisis" in March of this year.

Bob Michele, Chief Investment Officer at JPMorgan, indicates that further increases in the 10-year Treasury yield could elevate the risk of breakdowns in other markets and could tip the economy toward recession.

Michele states, "If long-term rates exceed 5%, this will certainly be another rate shockYou must keep your eyes peeled for anything that appears fragile."

The surge in Treasury yields fundamentally stems from a mismatch between supply and demand.

On the supply side, the U.S. government is likely to maintain a high deficit for the foreseeable future, indicating that massive bond issuance will persist

According to the Treasury Department, net issuance of Treasury bonds is projected to reach $1.01 trillion and $852 billion in the third and fourth quarters, respectivelyConcurrently, the Federal Reserve is continuously unwinding its bond purchases, reducing its holdings by a total of $1.3 trillion since 2022. This dynamic increases the supply of bonds flooding the market.

On the demand side, international investors are generally divesting their holdings, with total ownership decreasing by $121 billion since 2022.

This is particularly evident as Japan, the largest foreign holder of U.STreasuries, is adjusting its yield curve control policy, hinting at potential normalization of its monetary policyIf Japan alters its policy, the demand for U.STreasuries could diminish significantly.

Amidst the strength of the U.S. dollar, many emerging market currencies are experiencing devaluation, increasing the likelihood of selling off U.STreasuries to defend these currencies.

The sustained weakening of overseas demand has transferred the pressure of supply to the domestic front.

However, the reality is that there is limited domestic capacity for extensive bond purchases. During March, the U.S. banking industry suffered a liquidity crisis, which significantly hurt its capacity to absorb Treasuries, particularly those with longer durations.

As U.S

Treasuries consistently breach ceilings, long-term buyers are becoming scarceHow high can Treasury yields rise as this imbalance in supply and demand persists?

Nick Timiraos, known as the "new Fed whisperer," warns that the surging yields on long-term bonds are jeopardizing the hope for a soft landing in the economyThe sharp increase in borrowing costs could greatly stifle economic growth, raising the risk of financial market collapses and undermining the reasons for the Fed to raise rates again this year.

In fact, the Federal Reserve itself is grappling with losses of a magnitude not seen in over a century.

Following earlier expansions of its balance sheet and subsequent rate hikes, the Fed posted an operational net loss of $57.384 billion in the first half of 2023, and the total for the year may exceed $100 billion. The last time the Fed reported such an annual operational deficit was in 1915.

This loss at the Fed will directly impact federal revenues, meaning the Treasury may not receive net profit payments from the Fed until after 2026.

Despite the Fed's indication that operating losses and unrealized gains will not affect monetary policy, this may complicate its efforts to combat inflation.

The Fed might instruct regional reserves to pass operational losses onto their shareholders, and some member banks could become more vulnerable due to their capital positions.

Former Treasury Secretary Lawrence Summers has suggested that last month's employment figures indicate the Fed’s rate hikes are not functioning as they once did, increasing the risk of a hard landing for the economy.

Summers states that the acceleration in job growth may "make risks of a hard landing appear more pronounced." Interest rates may no longer act as they once did to guide the U.S. economy, implying that rates could have to fluctuate more drastically when the economy requires cooling

Advertisements

Advertisements