Crash, Burn and Yield

Last week will probably be remembered as the week in 2024 when changes bloomed. Canada saw the awkward Monday morning announcement by the government about changes to the first time home buyers program. There is still a lot to be written on the official rules that come out on Dec 15th, but it looks like it is bullish for housing affordability.

Mid week saw the release of the Federal Reserve minutes, and after 4 years of no cuts, Jerome came out swinging with a full 50 bp rate cut to start the easing cycle. There was much debate whether he would cut 25 or 50, and that got answered. Now begins the autopsy on whether we needed 50 bps, or if the data is weakening enough to support it.

No matter your feelings on whether 50 bps was too much or not enough, there is a very interesting trend developing in the bond market. Even though the Fed cut at the max that was expected, yields are still rising! US 1 year yields were down by 4 bps on the week ( 3.991 down to 3.951 ) and are the only outliers. Even seeing yields come down by 4 bps after a 50 bp cut to the overnight rate sheds some concerns. 2 year yields were up from 3.557 to 3.597 ( up 4 bps ), 5 year notes rose from a starting yield of 3.41 to end the week at 3.50 for almost 9 full bps, and the most heavily watched US10 year rose from a Monday open of 3.62 to a Friday close of 3.74 for a 12 bp increase. Hell, even the US 20 year yield increase from almost bang on 4% to end Fridays session at 4.125.

Could it be the bond market is throwing a temper tantrum like a 4 year old who has to leave a birthday party early? Is the fact the the US bond market just came off the longest inversion ever throwing some false signals? Both of these are possible. Maybe it really is different this time? The coming week will tell us if we just saw some pent up trading demand after Wednesdays announcement, or if we saw the algorithms get a little hyped up.

But, a larger concern that needs to be sticking in the back of our minds is something a lot scarier than some computer trading programs, or a new normal. What if the US Federal Reserve has lost control of the bond market? What if the bond vigilantes are back, and don’t care about what Jerome and Co. Tiff and Co. or any other central bankers have to say? What if people are waking up to the fact that the US has crested a 35 trillion dollar debt load, and is basically bankrupt? For years, decades really, markets have taken their que from the Federal Reserve, the BOC and the like. Markets have hung off of every word that central bankers say, taking it in like some gospel. What if the bond market has decided not to read from the good book any longer? What if Mr. Market has decided that government bonds should trade on the fundamentals?

All of these questions can have potentially devastating consequences for borrowers and lenders. If we look at how much debt the US or Canada has racked up since March of 2020, it is beyond comprehension. Trillions and trillions of dollars have been racked up. The cost to service these government debt loads is the largest line item in the government budget. What if there is a reckoning a foot in the bond market? What if the bond market has decided that the interest rate ( yield ) charged on the government debt should correspond to the perceived risk?

Please understand that my reason for mentioning these different scenarios is not to scare the pants off of people, but rather to highlight some potential changes that we may see. If, as this past weeks yield action suggests, bond markets are actually paying less attention to central bankers, then it may lead to some interest rate instability. Case in point was this weeks Canadian data, where we saw pretty much every single metric come in below consensus. The big announcement was of course inflation coming in at 2.0%, well under expectations, but CPI trim came in lower as did CPI core, and unemployment is going up faster than…. well… never mind – it is growing quickly. Every data point seems to be telling us the Canadian economy is in the crapper, but the Canada 5 year government bond yield was up almost 3 bps on the week ( the same week that had big brother USA cutting 50 bps off of the overnight rate ). Tiff has cut 3 times, and is expected to cut twice more in 2024, and the 5 year yield was still up on the week? Sure, the 5 year yield is down from the peak reached last year at 4.33%, and is trending lower, but for now I am wondering if we have seen the short term low in 5 year yields? Could we subsist at these levels for a couple months? I called the high yield on the 5 year Canada bond back in 2023, but am not ready to call the low on the 5 year just yet, but it seems we could be getting down to the lower end of the trading band.

Something isn’t making sense in the bond world. Maybe it is a nothing burger, but maybe it is a bacon double something burger – with extra pickles. If the bond market is going to start moving to a more fundamentals based approach then rates may move at different times for different reasons. The BOC press conference may not be the red carpet rockstar event people have made it into. Central bankers will still be important but may not move the bond market as much as actual data. Personally I long for the day when government who spend with reckless abandon are punished with higher borrowing rates. Yes, it creates a larger burden for the taxpayer, but it is the only way to cut the size of government in our day to day lives. At some point governments need to start living within their means – god knows everyone else has had to learn to.

If bonds traders start demanding appropriate compensation for the perceived risk they are taking then yields will have to rise. Of course governments can always intervene in the bond market – and have before, but we may be nearing the end of “endless debt with no repercussions” stage of the economic cycle. My hope is that the last weeks bond action was a fluke, a one off, and some screwed up computer code. My fear is that it is much more than that, and we need to adjust our businesses around what may become a different interest rate environment. Hopefully this week sees a correction to the path. If we continue to see bond yields defy central bankers and if that leads to central banks losing control of the bond market, we could be in for a new fun game in finance called crash and burn.