Bond Vigilantes Could Return as Fed Policy Falls Short of Projections
The rise in yields and interest rates are becoming a bigger issue for the markets.
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Markets reversed early gains for the second day in a row in the first full trading week of 2025 on Tuesday.
After a nice early rally, equities turn south. By market close, the NASDAQ had dropped nearly 2% on the day while the S&P 500 fell just over 1%. The yield on the 10-year treasury backed up by just over five basis points on the day to close near the 4.7% level. Thirty-year treasury yields are now at their highest level since late in 2023.
The Federal Reserve’s monetary policy does not seem to be working as projected. While the federal funds rate has been reduced by 1% since the first reduction at the FOMC in mid-September, the yield on the 10-year treasury has shot up just over 100 BPS since. As my late father like to quip, "Life is what happens when you are making other plans."
It is hard to see yields coming down much given that the federal government is racking up daily deficits of just north of $10 billion in the first two months of its fiscal year. When the debt ceiling is moved out sufficiently, that might bring at least some temporary relief. However, it is hard to gauge what the new administration will be able to get through congress in relation to extending the tax cut package of 2017 which expires at the end of this year. Or for matter, what other tax and other changes the new regime will be able to enact given they have the narrowest majority in the House of Representatives since 1931.
The U.S. is hardly alone in facing higher yields on its debt. Ten-year government debt in the United Kingdom just hit its highest yield since 1998. It feels like the bill is finally coming due for all the huge stimulus packages that sprang from the COVID-19 pandemic and its aftermath. Not to mention all the other taxpayer largess that has flowed across western economies in recent years. I am waiting for the term "bond vigilantes" to reenter the financial lexicon if yields continue to rise.
One thing is for certain: The market is not priced correctly if their rates stay at these levels or move higher. The S&P 500 started the year trading at just north of 22-times forward earnings. Other than the 1998-to-early-2000 era, those are the most extreme levels of my investing lifetime. One also has to remember the U.S. was on much more solid financial footing in the late 1990s as well. The country had four straight years of 4%-plus GDP growth from 1996 to 1999 and ran a small budget surplus at the end of the century.
In addition, as Doug Kass constantly reminds us in the Daily Dairy, the market is extremely top-heavy with the Magnificent Seven acting like the Nifty Fifty in the early 1970s. This is somewhat understandable that all the earnings growth within the S&P 500 over the past two years has come from technology, media and telecom.
The yield on the 10-year treasury crossed over the 4.7% level in pre-market trading this morning and will continue to be the biggest determinant of market direction in the months ahead. The market could face some challenging times in coming weeks as investors finally start to properly price in the "higher for longer" interest rate environment.
At the time of publication, Jensen had no positions in any securities mentioned.
