Before Hamas’s invasion of Israel, the stock market was teed up for a seasonal year-end rally. There had been lower-trending economic data to offset the still-stubbornly inflationary data to keep the bond market in check, and the dollar continued to trade higher, attracting foreign capital from around the world.
To the surprise of many, the first week of third-quarter earnings season produced some strong results for companies that reported on Oct. 13, but then a call for worldwide Jihad by the leader of Hamas triggered a risk-off atmosphere heading into the weekend that left the market twisting in the wind.
At Oct. 12’s Treasury auction, the 30-year yield jumped to 4.86 percent before the next day’s flight to safety. Bidders showed the lowest interest in long bonds since 2021, as evidenced by primary dealers’ buying 18 percent of the debt. (As a rule, primary dealers are required to take debt not purchased by other bidders.)
This was a red flag for future bond auctions, reflecting rising caution over a U.S. budget deficit that is generating rapid increases in costs to run the government. On Oct. 10, the Congressional Budget Office reported that the federal budget deficit for the 2023 fiscal year was $1.7 trillion, more than 20 percent over the 2022 deficit of under $1.4 trillion. Clearly, the bond market is saying “no” to further large increases in the debt ceiling, and the International Monetary Fund is the latest to chime in, with Pierre-Oliver Gourinchas, director of the IMF’s research department, saying, “Federal deficits have deteriorated substantially in 2023.”
The White House, Congress, the Treasury, and the Federal Reserve shouldn’t test the will of the bond vigilantes. It’s one thing when the underlying currency is weak and yields rise to attract capital, but it’s quite another to see the dollar engulfed in a bullish uptrend and still see the Treasury struggle to peddle its debt in one trainload-sized auction after another. I noted in recent comments that even if inflation were to get under 3 percent, it wouldn’t guarantee Treasury yields coming down. The United States’ creditworthiness is being called into question, and although the Fed votes only eight times per year, the bond market votes every day.
Are we living in the greatest credit bubble in human history? Apparently not, Treasury Secretary Janet Yellen said. In a recent Fortune article, Ms. Yellen said she is “not really concerned about the impact” that recent federal spending programs will have on the national deficit, arguing that the federal government just needs “to make sure that we stay on a sustainable course.” Ms. Yellen is behind the curve. When you can’t sell 100 percent of AAA-rated U.S. debt at an auction with rates at a 23-year high, I’ll borrow a famous quote: “Houston, we have a problem!”
Considering the recent hot CPI number and lousy bond auction, the mess in the Middle East is driving money back into Treasurys and shoring up a market that was on the cusp of some further unwinding. In doing so, it provides time for the White House, Congress, the Treasury, and the Federal Reserve to address the fragility of the bond market and provide some assurance that they are acutely aware of how reducing the deficit is a top long-term priority. God forbid they ignore the many recent red flags.
When the world stops buying your debt—as has been the case in Japan for years—then your own central bank becomes the biggest buyer of your Treasury’s bond issuance. As of March, the Japanese public debt is estimated to be approximately $9.2 trillion (1.30 quadrillion yen), or 263 percent of their GDP, the highest of any developed nation, and 43.3 percent of this debt is held by the Bank of Japan.
By this time next year, when our debt numbers are even more gross and Americans go to the polls, one can only hope this will be a front-and-center topic for most voters. Our kids and grandkids depend on it.
There is still the potential for the U.S. stock market to enjoy a year-end run, but much depends on how the Middle East situation plays out. It would help if investors see one heck of an earnings season, and Washington shows real resolve in getting Iran to back all the way down. Even so, excessive government spending has been exposed, as well as a gaping vacuum of leadership, respect, and the loss of what Teddy Roosevelt once called a “speak softly and carry a big stick” U.S. foreign policy. It’s one thing to show up with a mighty force, but it’s quite another for the evildoers to know and believe fully well that you will use it.
