Reality Catches up to the Bond Market

Bond yields soared on Friday with the !0-Year U.S. Treasury yield rising 14 bps to 4.6%. Meantime the yield on the 30-Year Treasury hit 5.12%, its highest since 2007. Globally it was the same story, as Japanese yields are at their highest level since 1997 and government disarray in the U.K. is sending yields soaring there.

What’s going on? Three critical factors are coming together: rising inflation, government deficits, and an AI capital spending boom. Triggered by soaring oil prices caused by the Iran War, the U.S. consumer price index (CPI) is now 3.8% over year ago levels, and the producer price index (PPI) is now 6% over the same period a year ago. To be sure, core inflation at the CPI level is lower at 2.8%, but the core PPI is now running at a high 5.2% rate. More concerning is the likelihood that over the near-term, inflation will move higher, not lower. This clearly is not an environment for rate cuts.

Second, huge fiscal deficits are the order of the day. The U.S. continues to run a $2 trillion deficits around 7% of GDP, and with tariff refunds and higher defense spending it will go higher. Although the rest of the G-7 is doing much better, ex-U.S. the G-7 is running a deficit of 2.4% of GDP.

Last, the AI boom in the U.S. is sucking capital in from all over the world. Witness Alphabet’s recent $60 billion global offering. Here are the AI companies that used to supply capital to the rest of the world; they are now massive users of capital. Hence real rates have to increase and in the short run the massive expansion of data centers will put upward pressure on the price of inputs, ranging from memory chips to electrical equipment and construction labor.

 

This is the environment that incoming Fed Chair Kevin Walsh is facing. It is hardly an environment to cut rates. Indeed, with the two-year note now yielding 4.08%, well above the current midpoint of the Federal Funds rate of 3.63%, the market is now pricing in a rate hike. Those who say that Warsh will follow Trump’s orders to cut rates will soon be disabused of that notion. Kevin Warsh does not want to be remembered as the Fed chairman who looked inflation in the eye and blinked.

 

Finally, it is important to recognize that the recent rise rate is taking place in the context of a structural bond bear market. (See: https://shulmaven.blogspot.com/2025/01/we-are-in-early-stages-of-bond-bear.html ) Bond bear markets, just like bond bull markets last a long time. The last bond bear market lasted 35 years, from 1946 – 1981. We are now only in the sixth year of the bond bear market that began in 2020, when the 10-Year U.S. Treasury Bond bottomed at 0.56% in August of that year. So, buckle up, we are still early in a very long cycle.

The Defanging of the Stock Market

 

April has brought with it the defanging of the stock market where the hitherto invulnerable FAANG stocks crashed and burned bringing with it a full-fledged bear market in the NASDAQ Composite Index. FAANG stands for Facebook (now Meta Platforms) Apple, Amazon, Netflix, and Google (now Alphabet). From their respective 52-week highs Meta is down 48%, Apple is down 13%, Amazon is down 33%, Netflix is down an astounding 73% and Alphabet is down 23%. Taken as a whole the NASDAQ Composite is down 23%. The weakness in these five stocks which at one time accounted for nearly a quarter of the market value of the S&P 500 brought that benchmark index down 14%.

 

Market behavior of this type is reminiscent of the 1973-74 and the 2000-02 bear markets. In the 1970s the so-called Nifty-50 group of one-decision growth stocks which were trading at 50-60X earnings experienced declines in excess of 50 -80% during the course of the bear market. In the collapse of the 2000 dot.com bubble such stalwarts as Cisco, Microsoft, Intel, and Oracle (a group of stocks that I then characterized as “The Four Horseman of the NASDAQ”) which traded at multiples in the 80-100X range lost about three quarters of their market value. Indeed, just as today, the stock market was bracing for a tightening of monetary policy. Needless to say, the history is not encouraging.

 

There are, however, two distinct differences between then and now. First, from 1972-74 the 10-year Treasury traded in a 6-8% range and in 2000-02 it traded in a 5-6% range far higher than the current 2.9% yield. Second, with the exception of Netflix valuations are nowhere near as demanding with Alphabet trading less than 20X earnings, Apple at around 25X, Meta at a below market 14X earnings. As a result, even if Treasury yields rise to 4%, my sense is that the worst of the declines in FAANG and the market as whole are behind us.

 

To be sure, we could soon be looking into the teeth of a recession triggered by a very aggressive Fed and continued high inflation which would haircut earnings estimates across the entire market. We are sure to have a recession at some point, but I do not believe it is soon. Simply put the end of the pandemic is fueling a consumer boom and capex remains strong fueled technology and energy related spending of all types. Thus, it will take more than 250 basis points of tightening to break this economy. Of course, if we are in a rerun of “That 70’s Show,” all bets are off. (Shulmaven: Roaring 20's or That 70's Show)

 

As I wrote in February(https://shulmaven.blogspot.com/2022/02/the-unravelling.html), my sense is that we are in a structural bear market in bonds and in for a very volatile stock market. Whether or not the lows are in or not, I do not know, but the world will not look as bad in December as market participants feared last week. Net, net although 2022 will be a down year for stocks, the market will end the year higher than where it is now.