The US presidential election Nov. 5 is shaping up to be the mother of event risks so you’d think the safest of all havens would be holding up. But it’s not — and that’s only one of the notable anomalies springing up in financial markets. Yields on 10-year US Treasuries have risen nearly 70 basis points since the Federal Reserve's punchy half-point initial rate cut on Sept. 17.
What’s even more unusual is that US sovereign bonds are having a wobble without instruments that are usually correlated coming along for the ride — with the exception of UK gilts, for similar fiscal worries. The US dollar has strengthened 4% over the past month, so it’s evident foreign money isn't fleeing US assets; it’s just not being parked in the usual safe spot of Treasuries.
So where are these dollars going? Some continue to head to the hottest game in town - US tech stocks. But this isn’t as clear-cut as it looks, if using the textbook method for equity valuation, which uses US Treasury yields as the discount rate for future corporate cash flows. This relationship determines the equity-risk premium compared with the fixed-income risk-free rate. When interest rates were near zero, it was the convenient explanation for the extraordinary rise of the Magnificent Seven’s share prices. Yet the old-fashioned way makes equities look overly rich to bonds — so either throw that theory out of the window or be prepared for a sickening reversal.
The valuation comparison is similarly stretched for emerging-markets debt, which, despite the kryptonite of an overly strong dollar and a repricing of the US Treasury coupon curve, is holding fast. At some point, something will break - and not just in the US.
The renewed selloff in the Japanese yen is a concern after Sunday’s election saw the ruling coalition lose its parliamentary majority. Intervention again to support its currency is a real risk. A sudden reversal of yen weakness in early August destabilized global markets, causing mass unwind of the popular carry trade of borrowing in low-yielding yen to finance higher-risk assets in other currencies such as dollars.
However, the most startling disconnect is within the US fixed-income space - with corporate credit spreads tightening despite the exodus from the sovereign benchmark. High-yield spreads have narrowed 150 basis points in the past year - and are near record tightness. Debt capital markets are in rude health with new bond deals this year matching the volumes and variety of credit quality as in the pandemic’s banner years.
With so much in Goldilocks territory, Washington must be the problem here. The economy is broadly ticking along nicely, but importantly neither is it too hot. Weaker September housing data and durable-goods orders, along with the Fed’s Beige Book regional survey, point to large swaths of the economy slowing rapidly. The Bank of America October fund manager survey showed 76% of respondents still looking for a soft landing. The Fed has repeatedly made clear it views monetary policy is too restrictive. Rate cuts may come at a slower pace, but the direction of travel is clear.
This isn't really an inflation-driven scare either, as the Fed's preferred core Price Consumption Expenditure gauge is close to its 2% target. Persistent weakness in the crude oil price would normally be helping bonds. Yields on Treasury Inflation-Protected Securities have matched about half of the increase registered by their nominal brethren, but now return 2% after inflation — close to the most generous since the global financial crisis.
What is notable in the past month is a rise in the cost of buying downside option protection — along with pressure in the repurchase markets. That indicates not only an increase in portfolio hedging but also short positions being put on. Bond-market volatility is the highest since late last year but this may shelve off sharply post Nov. 5.
Fear of the unknown is an ephemeral thing even if nothing much in the real economy has changed. Any incoming administration’s capacity to splurge fiscally will be heavily limited, not just legislatively but by bond-market appetite. Reality will hit hard if nothing can be funded. Once the event risk of the election passes, the elastic of the fundamental valuation relationship of the global bond benchmark to other asset classes could well snap back.
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