Why This One Thing Has the Biggest Impact on the Long End of Yields

Following up on Friday’s report on bonds, let’s look at what impacts the long end of the bond yield most. It’s not necessarily what the Fed does and it’s not even the data. It’s supply and demand.

Let’s break it all down, and see my take on the market right now:

Investment Grade Vacuum Cleaner

New issues of investment-grade bonds are now sucking up duration like never before. Bond investors tend to think of their bond exposure in terms of dollar value of a basis point, or some measure of duration (less sophisticated, but sufficient for many purposes). Now, get this: August had $100 billion more of new issues in corporate debt than the average of the prior three Augusts.

But even the sheer amount doesn’t tell the full story.

A total of $100 billion of two-year bonds is not the same as $100 billion of 10 year bonds. The “notional” risk is the same, but the real risk (on a mark-to-market basis) is dwarfed by the longer-dated bonds. Their dollar value of basis point/duration is much larger.

Investors can pick and choose how much risk they want in bonds, and the total money to invest can change depending on how long or short the investor goes (typically they can invest fewer dollars in longer-term bonds for any degree of risk they are willing to take).

What we’re seeing is longer average maturities, which in turn means longer average dollar value of basis point/duration ).

So the combination of more debt issued with more risk per bond mean that bond investors are being asked to absorb so much more supply than ever before. So, just talking about the dollar amount, understates that risk by a lot.

This is the single biggest issue facing sovereign debt issuers (not just here, but globally).

Increasing Sovereign Debt

Sovereign debt issuance is also increasing. The amount of Bunds outstanding (German government debt) has grown by about 40% in the past five years. That’s not big, in and of itself. But it’s part of a trend for more debt globally. That global supply is only going to increase as countries will be issuing more and more debt to fund defense and infrastructure. This creates more options for buyers.

The Demand Side Isn’t Helping

Most of what is occurring globally is not nefarious nor is it retaliation to what the U.S. policy has been on trade and tariffs. What is happening is a natural phenomenon, which in some cases is a direct result of U.S. policies. Countries are spending more on defense and infrastructure. Globally, oil prices are higher, tending to force more issuance, at higher yields. There are some “prudent” risk management steps that are likely being taken by foreign countries to reduce their exposure to treasuries (which is easier when bond yields globally are higher).

Norway announced reductions in allocations to sovereign debt. This seems to be a “portfolio” level decision, affecting all their purchases of sovereign debt, but it will mean less demand for Treasuries.

The Saudis are looking for loans. One offshoot of the war in Iran is that countries like Saudi Arabia need to borrow to temporarily adjust to oil disruptions, repairs, and defense spending. Presumably the Saudis will be buying fewer Treasuries (their holdings have dropped from $160 billion to $142 billion since the war on Iran started).

Japan, with over $1 trillion in Treasuries, has seen its holdings decline, and presumably Japan won’t be buying a lot of Treasuries while trying to strengthen the yen (a policy move supported by U.S. Treasury Sec. Scott Bessent).

I have no idea what Canada or the European Union will do, but it’s difficult to imagine them adding to Treasury holdings while trying to raise money to support defense and infrastructure spending.

Again, I don’t see this as “anti-American selling” (though there is an element of risk to that). It is simply that we are living in a world where supply of debt is increasing and potential sources of demand seem to be waning.

What About 60/40?

What about the 60/40 portfolio? Many readers at TheStreet Pro face this decision in the portfolios they are responsible for. While the 60/40 allocation (60% equities vs. 40% bonds) remains popular, it is easy to find more and more advisers questioning it. Bonds have not been acting like a great hedge. With life expectancy increasing and the stock market booming, 40% in bonds is deemed too high by many (or more accurately, the argument for owning more “risky” assets, like stocks, for people with multi-year (or decade) time horizons has been gaining traction). I suspect this is playing a minor role in rising bond yields, but is a factor worth considering.

With a lot of confusion over the direction of longer-term yields, and a Fed that is almost certainly not going to cut any time soon (I’m firmly in the “no hike” camp), it is easy to see
why there are all-time record allocations to money market funds.

The Treasury is taking advantage of tapping into that pool by issuing T-bills. That allows the Treasury to issue fewer longer-dated bonds, but is kind of a drop in the bucket relative to the overall supply and demand dynamics.

The User Fee Wildcard

I really don’t want to go here, as it seems like a horrible idea, and hasn’t really been floated in a long time, but with Pres. Donald Trump ramping up his frustration at high yields and deficits, it would seem remiss not to mention that former Federal Reserve Board of Governors Stephen Miran, in the past, published papers on a variety of topics, including a “user fee” on foreign official (central bank and sovereign) holdings of Treasuries.

I expect that “work” to stay buried as it seems against much of what Bessent would advise, but kind of makes you think.

The Fed Operation Twist Wildcard

If the administration wants to get serious, a “Fed Operation Twist” is a necessary step. Hiking and “favorite inflation metrics” have been the flavor of the day, but this remains a powerful tool that should be on the table (it probably isn’t, but it should be).

Equities May Face Supply Issues

We’re excited about the rejuvenation of the initial public offering market. It is great seeing new companies go public, providing different risk/reward characteristics than existing companies. It has also been compelling to see existing companies issue equity to get ahead of the compute spend.

We expect to see a wave of new IPOs. The market is strong and looking to add new and unique profiles. AI and compute will lead the way, but there are a plethora of opportunities.

Again, some of these new listings will have market capitalizations that used to belong only to longtime public companies.

There will be some lockups expiring on earlier IPOs.

Quite frankly, for the vast majority of these companies, Treasuries 10, 20 or even 50 basis points higher than where they are now is a non-issue. It should be a hectic market for equity capital markets (alongside debt capital markets). Markets are strong enough to absorb the supply, but it could be a bit of a headwind.

Bottom Line

I continue to like owning “compute” bonds on a yield basis (no rate hedge). Supply should come, but investors have set aside capital to buy this paper.

Be cautious on the longer end of Treasuries. This is far more about supply and demand, and market supply is not helping. The demand side isn’t helping either, and so far Treasury has brought out the peashooter rather than the bazooka.

On the front end, buy whenever the market gets close to pricing in two hikes by January, and sell when it goes down to a ½ hike priced in for this year (I still do not think we get a hike, but need data, even my alternative favorites, to support that).

We’re also hearing a lot more about rare earths and critical minerals as the meeting with China’s Pres. Xi Jinping approaches. Maybe the meeting will go so well that any fears will be assuaged, but I’d be adding to energy, infrastructure, domestic production, and commodity processing, refining, and smelting bets ahead of the Xi meeting, both domestically and globally.

Normally we could say something like “Let’s Get Ready to Rumble” as we get past Labor Day, but it seems like we never stopped rumbling this summer.

Look for supply and demand to be more important than data in the coming weeks.

At the time of publication, Tchir had no position in any security mentioned.