Bond. Treasury Bond.

Bond. Treasury Bond.

There’s a lot going on in markets, right now. In cases like these, I think it’s important to figure out what the key drivers are. What’s signal and what’s noise? That’s not necessarily an easy task, but I think it’s worth trying.

One way to think about it is to consider what exactly changed? For instance, right now bonds have gone from trending down to falling down, while stocks have started to join the downside party, again. Why?

Good question, and there are a lot of potential answers. Again, my attitude is to consider what changed. In this case, I’d point to three different, if related, things. Japan, bonds, and liquidity. I’ve spent the last two weeks flogging Japan, so this week, let’s move on to bonds.

What’s wrong with bonds? Again, there are many opinions. To my mind, the most meaningful change was the Treasury refunding announcement. We’ve spent the start of the year issuing somewhere between few and no Treasury bonds as we prepared for and dealt with a debt ceiling crisis.

Issuance matters because the government will get funded, one way or another. If they say they need $100B of bonds funded, they’re going to get that money. It’s just a question of at what price that must happen.

The shape of the funding also matters. When a security is issued, it sticks around until the end of its term. If the government issues a T-bill, that money is captured for days, then goes back into the economy. The impact is minimal. If a 30Y bond is issued, the money spent on that bond is captured for 30 years. In both cases, the funding will pay for federal spending, but with the Treasury bond, the money is more frozen.

The market started going down when the Fed announced more Treasury bonds were going to be sold, and the pressure will also be on when those bonds actually get sold. Ignoring the possibility of another debt ceiling fight in October, that’s a new headwind that’s going to be with us for the rest of the year, as heavy deficit spending needs funded.

The next interesting question is where the money is going to come from to fund the government. The bond market would be a logical first guess, but not right now. The reason is that the term premium is negative. Why sell your 6-month T-Bill at 5.47% to buy a lower yielding 30Y bond at 4.26%? You may, if you want to lock in that return because you fear lower rates are coming, but that’s a recession trade. Right now, people are excited about a strong economy, not recession.

If not the bond market, then where does the funding come from? Foreign buyers aren’t buying. There are some natural buyers, like banks and pension funds, but they can’t handle all the supply. Ultimately, this needs funded, and that likely hits the canaries the most. When funding needs arise, the most delicate entities feel it the hardest. In this case, the no-earnings tech highfliers are the ones most open to downside.

Maybe that sounds crazy, but you can see this in effect, as the S&P 500 is down 3% from the top, the Nasdaq 100 is down 5.6%, and the highflying ARKK fund is down 21%, all largely within the last two weeks.

Things don’t have to happen in a straight line, but this effect seems pretty logical and in line with what we’ve seen historically. Buying no-earnings growth stocks worked great when liquidity was flowing more freely earlier in the year, but it looks like that’s changing. Plan accordingly.