Back in August last year I wrote the article “IF THE FED CUTS RATES, THE DAMAGES WILL BE FAR GREATER THAN THE BENEFITS” to deliver the following warnings:
“To all those who advocate rate cuts because those will benefit the economy, I dare to ask where exactly the economy will benefit in the current situation. A rate cut will not only risk triggering a resumption of forced JPY carry trades unwind, eventually putting stocks back on the brink of crashing because of forced deleveraging, but will clearly reignite inflation in a country already dealing with a cost of living more and more unaffordable for a larger and larger portion of the population.”
“As if what I described wasn’t enough already, if the FED cuts rates, there is the ultimate risk of triggering an inversion of the US yield curve back to upward sloping. If that happens, it will be hard for the global financial house of cards to remain standing as it has happened every single time in the past”
Fast forward to today, it is now clearer and clearer for more and more investors how the FED delivering unnecessary rate cuts in 2024, whose only purpose was to pump stocks for the benefit of the Democratic presidential campaign while hiding the whole mess the previous administration made in the economy (above and beyond what previous ones before of them did), was a bad and is turning out to be an expensive mistake.
Donald Trump had the opportunity to slam on the brakes and stop the US economy train from heading towards a cliff, but as I anticipated in the article “WHY MAKING AMERICA GREAT AGAIN IS SUCH A BAD NEWS FOR MANY (GREEDY) US INVESTORS” the process would have been very painful for the stock market that threw such a big tantrum that the current US administration was forced to U-turn on its (to be honest ill-conceived) plans. However, while stocks recovered all the steep losses of the month of April, bond investors did not play ball with it. At first, Treasury yields started to rise again mostly because of hedge funds selling safe assets to move back into risky ones as I explained in “TARIFF WARS ARE OVER FOR NOW, BUT NEVERTHELESS THE INFLATION SPIRAL WILL CONTINUE“, but as expected it did not take long for traders, especially bond ones, to figure out inflation is going to come roaring back up not only in the US but also around the world. Why? Because the tariffs charade will resume in about 6 weeks and many trading partners are not going to be able to convince Donald to scrap all new tariffs slapped on them, but now that it is clear the US deficit problem won’t be seriously tackled (especially when the US administration is about to pass a big tax cuts bill), US debt will continue growing and require more monetization effort from global central banks to keep it sustainable. BOJ, BOE, and SNB are dealing with mounting problems in their own domestic financial systems, the reason why as I warned a while ago again: “WITHOUT THE FED RESUMING QE, THE US WILL FACE A DEBT CRISIS VERY SOON“.
Enough is enough for bond vigilantes who are now more and more taking with a grain of salt whatever promise is delivered by politicians, and rising yields are now starting to undermine this last (ridiculous) stock market rally. Yesterday stocks did not turn significantly lower “out of nowhere” but the reason was an ugly US Treasuries auction that made it clear how bond vigilantes are starting to play hardball. At exactly 1 pm EST, the US Treasury Department held a $16bn bond auction for 20-year US Treasury bonds that cleared at 5.047% or 24 basis points higher than the previous auction roughly a month ago. This by itself wasn’t the warning sign; what spooked markets was the “tail” of the auction defined as the gap between the rate traders expect these bonds will be paying before the auction and the rate where these bonds will clear after the auction. A big tail signals weaker demand than was anticipated. The tail of this auction was 1.2 basis points which might look small in appearance, while in reality it is quite large and the largest in over a year as a sign of bond traders’ reluctance to buy Treasuries at the current yields. As soon as the result of this auction was out, the 20-year yield in the market jumped from 5.03% to 5.12%, the 10-year spiked above 4.60% and the 30-year roared above 5.10%. This was too much for stock traders to ignore and as a result, they started selling because, let me remind everyone, high rates are bad for stocks and all traders so far kept bidding risk assets hoping rates would come lower as the FED and the US administration kept promising.
Suppose bond vigilantes remain in the driving seat. In that case, the ripple effects in the global financial system are going to be brutal for all those countries that for years got away with unsustainable deficit spending monetized by central banks’ money printing. While everyone’s eyes are currently on US yields, those countries that stand to fall into serious trouble first are Japan and the UK. In the first case, the BOJ has already lost control of the long end of the JGB curve with yields now at levels that should prompt everyone to question the solvency of its insurance and pension system along with some “maverick” banks like Norinchukin.
In the case of the UK, yields are now trading beyond the levels that years ago triggered the insurance and pension funds crisis in the UK during the brief but disastrous time of the Liz Truss government. How come we don’t see a similar crisis unfolding again right now? Because the Bank of England has been bailing out its local financial system since then. On one side they set up a bailout facility that lends liquidity outright to financial institutions in such bad shape that they don’t have decent assets left to post to the BOE as collateral. On the other side, the BOE has been injecting liquidity through its short-term repo facility, let’s not forget one that was meant to be just “temporary”, but that is already lending more than 60bn GBP to financial institutions in the UK. Who is getting bailed out by the BOE? I am sorry, but the public better not know otherwise “panic” can spark in the markets, and as such the BOE publicly stated it will keep the names of these financial institutions in trouble confidential. How long will it be able to do it before people start figuring out who is in trouble and react accordingly? Who the hell knows, but by experience I can tell you that in these types of situations, things can turn nasty all of a sudden.
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