Will the US Bond Market Break?

People worry about the riskiness of stocks, but bonds can be just as risky Peter Lynch

Rear View Mirror

Forward-looking indicators for the US point toward a recession. However, measures of inflation and employment, both lagging indicators, do not. It is these more lagged indicators about which the Fed is most concerned. And as we know, despite its apparent desire to drive using its rear-view mirror, the Fed is on course to tighten until something it cares about breaks.

It's the Bond Market Stupid

The UK has recently demonstrated that breakages can occur in the financial markets before reaching the real economy. While most analysts look at survey data from ISM, PMI, or GDPNow as precursors for a Fed pause or pivot, the risk vector is the US bond market. The Treasury market (or an adjacent piece of financial plumbing) is the most likely limiting factor to Fed tightening.

Doom Loop Risk

QT is currently mainly passive. The Fed is allowing Treasuries to mature from its balance sheet. But the looming problem ahead when the Fed turns a net seller is insufficient external balance sheet capacity. Foreign pools of capital are not buying Treasuries. In fact, due to dollar strength, they are starting to sell Treasuries to defend their currency, as the BoJ did recently. As the gilt market recently experienced, the US Treasury market risks running out of buyers. And when the last buyers turn seller, the doom loop scenario takes hold.

Balance Sheet Storage

Lyn Alden pointed out that “there are similarities to when the oil price went negative in April 2020. Did the market truly assess oil to have a negative value? Not really. There wasn’t anywhere to put the supply. Similarly, the US Treasury market risks running out of balance sheet storage capacity”.

The Kindness of Strangers Can Run Out

Jeff Snyder, on Euro Dollar University, explains how the world’s two largest owners of US dollar reserve assets, China and Japan, risk running out of capacity. China has used over $1tn of US dollar reserves (a third of its total) in the last decade. In the case of Japan, in August 2022, it spent 50% more of its US dollars to buy 2% more imports than in 2021. Both the Yen and Renminbi have continued to depreciate further against the dollar. Other currency blocs face similar issues. Eastern Europe is seeing twice the rate of inflation we have just reported in the UK. Many countries are being priced out of their traditional import markets.

The Bloomberg charts below illustrate the increased volatility and illiquidity in the world’s benchmark bond market.

DXY Watch

The US dollar is overbought and over-valued on most measures, yet everyone remains bullish, and the dollar’s strength can continue for some time. But when economies suffer sustained monetary pressure, the release valve is either the currency or the bond market. (In Japan’s case, it has been the currency. In the UK’s case, it was both). The US bond market is looking more fragile than its currency. However, the DXY dollar index may yet signal further signs of stress. US dollar strength is ultimately unsustainable. How or when it might unwind is unknowable, and the consequences of an unwind are also currently unknowable. However, further bouts of dollar flow volatility and market stress look inevitable.

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