Centerfin Collective Weekly

Centerfin Weekly October 21, 2022

Market internals tell a different story, How much higher can yields go? The return of the bond vigilantes

Market internals tell a different story than what you might expect

In volatile times, market internals can often provide clues to what’s to come.  Market internals refer to the underlying sector and factor performance. Last year, much of the gain was led by what is considered defensive such as FAANG and consumer staples, while cyclical stocks and riskier growth stocks struggled. This provided a tell for the action this year.  Since the June lows, we have noticed that certain risk-on sectors have not made new lows and have outperformed the broader indices.  Small caps, energy, financials, industrials, consumer discretionary, and biotech are outperforming the S&P 500, while real estate, the Nasdaq 100, utilities, and consumer staples are underperforming.  The market has priced in a lot of bad news, and perhaps this relative outperformance is a glimpse into the new market leadership once we come out of this bear market. 

How much higher can yields go?

Yields on US treasuries continued to move higher this week, reaching levels not seen since before the Global Financial Crisis.  The market is now pricing in a terminal rate, or the level to which the Federal Reserve will continue to raise until stopping, at close to 5%.   This is a similar level to where rates were before the financial crisis; however, what is different today is that the total debt outstanding is more than 3x what it was back then.  There is currently over $30 trillion of US government debt outstanding.  At these levels,  we would be approaching over $1 trillion to pay interest each year.  To put this in perspective, the projected interest expense for 2022 is $400bn.  Social Security, our largest expense is $1.2 trillion, and Defense, our second largest expense is $750bn.  At some point, the math does not make sense.  Taxes have to go up, or cuts have to happen to other parts of our budget.  Neither of those seems feasible currently, so we would have to grow the deficit significantly.  A growing deficit has wide-ranging implications, all of which are a headwind to the country.

The return of the bond vigilantes

Only 44 days after being elected, Liz Truss resigned from her position as the Prime Minister. The main reason seems to be her botched tax-cut-focused budget announcement which sent the British Pound plunging and yields on UK government bonds surging. This led the Bank of England to launch emergency measures to stabilize the bond market. In the early 1990’s yields on the US 10 yr bond rose from 5.2% to just over 8% in less than a year, fueled by concerns about federal spending.  Bill Clinton, then the President, was forced to make a concerted effort to reduce the deficit (see above).  The market participants behind this yield move were referred to as the bond vigilantes.  We have now witnessed a return of the bond vigilantes, this time forcing the resignation of the PM of the UK.

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