During earnings season, one might expect company fundamentals to have the strongest influence on the stock market. However, in recent months, it's become clear that the Treasury market is actually playing a larger role in driving stock market movements.
Volatility in Bonds
While stocks have experienced their fair share of volatility, the wild ride in bonds surpasses anything witnessed in the stock market. The 10-year U.S. Treasury yield, which stood at 3.95% at the end of June, surged to nearly 5% by mid-October—its highest level in 16 years. Buyers were enticed by this attractive round number and swiftly entered the market. By November 3rd, the yield had dropped to 4.52%, and stocks followed suit. The S&P 500 index fell 10% between July and October, only to rebound by an impressive 75%.
Bonds' Impact on Stocks
Once again, bonds have demonstrated their influence on the stock market. During a $24 billion auction of 30-year U.S. Treasury bonds held last week, there were signs of weakening demand. Primary dealers were required to accept 25% of the offering—double the average over the past year. The auction also had a large "tail," indicating that the Treasury had to offer a premium yield to attract buyers when compared to the prevailing market rate for 30-year bonds. In response, the S&P 500 lost 0.8% on that day, interrupting its recent rally.
This recent bond auction may serve as a sign of things to come. The federal government ended its fiscal year in September 2023 with a deficit of $1.7 trillion—an amount greater than its entire debt back in 1985. Such heavy borrowing inevitably leads to increased Treasury issuance. However, the two major buyers of the past decade—the Federal Reserve and China—have pulled back from the market. The Fed's quantitative tightening measures and China's own issues have contributed to a limitation in Treasury demand.
Given these circumstances, it's understandable that experts are concerned. Tim Horan, Chief Investment Officer for Fixed Income at Chilton Trust, admits that a failed Treasury auction is what truly keeps him awake at night. Describing it as a "Minsky moment," he refers to a potential market collapse caused by the sudden unwinding of excessive debt.
If anything, recent events have reinforced the notion that bonds possess a significant influence over the stock market. As we enter a future characterized by heavy Treasury issuance and reduced demand, it becomes paramount to pay attention to this often-underestimated driving force.
The Growing Influence of Fiscal Policy and the Uncertainty of Interest Rates
The impact of fiscal policy on the yield equation continues to strengthen, with the U.S. federal deficit taking center stage. As Congress approaches a Friday deadline to avoid a government shutdown, hopes of them balancing the budget seem unrealistic. Instead, a government shutdown or a continuing resolution that perpetuates the current overspending situation are more likely outcomes. This raises the possibility of the 10-year Treasury yield reaching 5%, which is not out of the question.
Adam Abbas, co-head of fixed income at Harris Associates, suggests that in the near term, there is a risk of yields increasing. The significant supply of Treasury bonds combined with the growing deficit narrative in Washington indicates a lack of a long-term solution. Concerns around Treasury borrowing also adds another variable to the Federal Reserve's calculations, in addition to inflation and employment, potentially unsettling the stock market once again.
However, while fiscal policy gains momentum, the influence of the Federal Reserve remains relevant. Although there is speculation that the Fed might halt interest rate increases, Chairman Jerome Powell emphasized that further rate hikes are still a possibility. Inflation has caused policymakers to hesitate in their decisions, and it will require sustained disinflationary momentum over several months to confidently declare success.
Despite these uncertainties, the market experienced a relatively uneventful week. The S&P 500 saw a modest gain of 1.31%, with the Nasdaq Composite rising by 2.37% and the Dow Jones Industrial Average increasing by 0.65%. This stability aligns with the 10-year Treasury yield holding steady at around 4.63%.
Looking ahead, the next long-bond auction is scheduled for November 20th. The market's apprehension towards the scale of Treasury borrowing introduces an additional element impacting the Fed's decision-making process. It is becoming clear that the world of Treasury bonds is dictating stock market movements.
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