Rising rates are no good for bond traders. Each time the Federal Reserve hikes its benchmark rate, older bonds with lower rates become less valuable, forcing arbitrageurs to search for higher yields.
Accordingly, in the last several months, investors have bet against long-term US Treasury debt. In October, 10-year Treasury yields peaked at 5%. That was the highest level since 2007, when the US central bank was raising interest rates in a last-ditch attempt to cool the housing market (it didn’t work, of course; instead there was a crash one year later).
But the Fed’s Nov. 1 decision to hold interest rates steady, along with the latest economic data, appears to have turned the tide back toward fixed-income investments. That, and changing positions among some legendary (or at least loud-mouthed) investors.
This past Monday morning, Bill Ackman and Bill Gross woke up feeling talkative. First, Gross, the “Bond King,” said he thought the yield curve would go positive by the end of the year—that yields on short-term debt would finally fall below those for long-term debt after 14 months of inversion. Then Ackman, a hedge fund manager known for his boardroom activism, said that he had covered his long-term bond short—that is, he stopped betting that the price of the debt would fall.
Lo and behold, it appears they are right—for now.
What does the change in the bond market mean for the rest of the economy? It means these market observers think the Fed is going to stop increasing rates, and even begin cutting them sooner than markets anticipated. But how we get there is a matter of debate.
What would cause the Fed to start cutting rates?
There are several possible scenarios that could lead to the Fed to start cutting. One is a debt disaster, as proposed by a different famed investor, Stanley Druckenmiller. He’s been fretting about US government debt this week and is predicting a recession due to high rates crimping economic activity. (He was also predicting a recession driven by the Fed this time last year.) That has led him to bet against long-term bonds but pile into short-term ones, with an overall long position.
The US government’s annual borrowing grew again after falling last year, and observers question whether House Republicans in disarray are capable of making any kind of budget deal. But it’s hard to attribute the now-rising price of long-term bonds to improvements in the budget.
Ackman and Gross are less concerned about debt, and more concerned about risk and the Fed’s path forward.
On the risk front, geopolitical tensions are on the rise in the Middle East, Ukraine continues to fight off Russian invasion, and the macroeconomic outcome seems uncertain—situations that tee up a potential flight to safety. That occurs when investors plunge into the debt markets to seek the safest home for their money in times of crisis, a situation that could blow out anyone betting against bonds. (You can see it happening in the chart above after Hamas’ Oct.7 attack on Israel.)
From a pure bond-betting perspective, the Fed is clearly reluctant to keep hiking rates. The latest estimates of US employment show a cooling labor market after a net increase of employment of just 150,000 in October, lower than the 276,000 forecasters expected. That reinforces the idea that high interest rates are pulling demand out of the economy, and the Fed was right to stop hiking.
Or, as Gross put it, “‘higher for longer’ is yesterday’s mantra.”
The question of whether this means a recession is coming is an open one. The Federal Reserve Board isn’t predicting one, according to Fed chair Jay Powell. Nor is the Atlanta Fed’s GDP tracker, or Goldman Sachs’ economic forecasters. That could mean a soft landing is within reach, or that the Fed is behind the curve once again. But slowing expansion does seem to spell the end of interest rate hikes—at least, if there’s not a hot inflation print on Nov. 14.