Rate Cuts Do Not Guarantee a Bond Market Rally

Fed Chairman Jerome Powell told markets that the economic conditions warranted a decline in the Fed Funds Rate at the August Jackson Hole meeting when he said:

“The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.”

The central bank’s FOMC followed through on the Chairman’s comments at the September meeting, cutting the Fed Funds Rate by a more-than-expected 50 basis points to a midpoint of 4.875%. The central bank has shifted to a more accommodative monetary policy approach, indicating that short-term rates will decline another 50 basis points by the end of 2024 and 100 basis points in 2025.

After receiving significant criticism that the central bank waited too long to increase interest rates as inflation rose to the highest level in decades and was not “transitory” after the global pandemic, the Fed does not want criticism that it waited too long to lower rates. Inflation has been trending lower, and employment has edged lower. The Fed’s mandate is full employment and stable prices, with its only substantial monetary tool controlling short-term interest rates. Meanwhile, market forces determine long-term interest rates which have not moved lower over the past weeks.

Conventional wisdom suggests that an accommodative Fed will ignite a rally in the U.S. government bond market, but the current environment does not guarantee that bonds will rise.

U.S. debt is high and continues to rise

• At $35.417 trillion and rising, the U.S. national debt erodes the creditworthiness of the U.S. government’s debt.
• Short-term rates at 4.875% mean that if receipts and expenditures are balanced, the debt will rise by over $1.725 trillion annually.
• The odds favor more expenditures than receipts. Statista forecasts that the U.S. national debt will rise to over $54 trillion by 2034.

The dollar’s reserve currency status has declined

• The U.S. dollar has been the world’s reserve currency since 1920.
• Since 1450, the average term for a reserve currency has been around a century. Portugal ruled the financial world from 1450-1530. Spain took over from 1530-1640. The Netherlands was the leading economic power from 1640-1720. France took the reserve currency baton from 1720-1815 when Great Britain and the pound held the position from 1815-1920. The U.S. dollar’s term is now 104 years old, and history tells us the sun could be setting on the currency’s leadership role.
• The bifurcation of the world’s nuclear powers, sanctions, and trade barriers have led the BRICS bloc to develop a currency to challenge the dollar’s dominant role. A BRICS currency with some gold backing could diminish the U.S. dollar’s position as the reserve currency.

Traditional bond buyers have retreated

• The U.S. has depended on foreign buyers of U.S. government debt, with the foreign ownership growing from 5% in 1970 to 23% in 1995 and 29% in 2023.
• China is the world’s second-leading economy and a top owner of U.S. debt.
• China’s holdings of U.S. government debt securities have declined over the past decade despite the increase in U.S. debt.
• China’s reduction of U.S. debt holdings weighs on bond prices and increases interest rates, making funding the debt more expensive.

The U.S. election reflects a divided country

• In a little over a month, the United States electorate will decide if Vice President Kamala Harris will become the nation’s leader or former President Donald Trump will serve a second term.
• The polls indicate a very close race that swing states will decide.
• Half the country will be unhappy with the result as political lines divide the U.S.
• Abraham Lincoln said, “A house divided against itself cannot stand.” Domestic political division erodes the full faith and credit of the U.S., weighing on bond prices.

The products that could benefit from lower bond prices

• The Fed could become accommodative and slash short-term rates, but market forces establish long-term rates.
• The ProShares Short 20+ Year Treasury ETF (TBF) is inverse to the bullish TLT product.
• The ProShares Short 7-10 Year Treasury ETF (TBX) is a short medium-term maturity inverse fund.
• The ProShares UltraShort 20+ Year Treasury (TBT) provides for 2X the negative return of the TLT. Leveraged products involve time decay risk as they create gearing through swaps and options. Leveraged products will decline if the underlying market moves contrary to expectations or remains stable.

In 1789, Benjamin Franklin said, “Nothing is certain except death and taxes.” There are no guarantees that a more accommodative Fed will push medium and long-term U.S. government debt securities higher and interest rates lower. Markets reflect the economic and geopolitical landscapes, which are not bullish for U.S. debt securities in 2024. Moreover, if the U.S. dollar ends its term as the world’s reserve currency, full faith and credit will decline and it could cost a lot more to finance the rising debt level over the coming years.

Thanks for reading, and stay tuned for the next edition of the Tradier Rundown!