Odd Lots - Lots More on the Global Selloff in Government Bonds

Episode Date: January 10, 2025

One of the biggest stories in markets right now is the huge selloff in government bonds. And we're not just talking about the US here. The UK is seeing multi-year highs in long-end yields. So is Japan. And of course, the US 10-year Treasury is close to its highest level in a year, despite the recent rate cuts from the Federal Reserve. So what's going on? Is it just about inflation and growth expectations or is there more to it? On this episode, we speak to Jay Barry, head of global rates strategy at JPMorgan Securities, who breaks it all down and gives us his estimate of where fair value now stands.Read More: Fed’s Barkin Says Term Premium Moving Long Rates, Not Inflation Only Bloomberg.com subscribers can get the Odd Lots newsletter in their inbox — now delivered every weekday — plus unlimited access to the site and app. Subscribe at bloomberg.com/subscriptions/oddlotsSee omnystudio.com/listener for privacy information.

Bloomberg Audio Studios, Podcasts, Radio News. Joe, are we going to spend this episode just arguing about the term premium? I don't know, like, yeah, maybe. You know, I've always, like, I've always been sort of, I wouldn't say a term premium denier, but I'd never totally. Yes, yes, you are. Okay. But like, and I was totally ready to capitulate. I was like, oh, it's all the term premium.

And I was like, I'm totally convinced the term premium is this really important concept that can be measured analytically with precision. And then to people like, oh, it's actually, you don't really have to go that far. It's sort of straightforward. I still don't know. You know, there's a middle path where you can say that the term premium is hard to measure because you have to estimate like a risk-neutral rate. But it still exists. It might mean different things to different people, but.

I've never been good in life at taking the middle path in anything. I oscillate between extremes. I did a dead list. I'm both the most popular trader and most successful trader at Citadel. Fed is going viral. Barges. This is an after-school special except... I've decided I'm going to base my entire personality going forward on campaigning for a strategic pork reserve in the U.S.

Black gold! These are the important questions. Is it robots taking over the world? No, I think that, like, in a couple of years, the AI will do a really good job of making the oddlots podcast. One day, that person will have the mandate of heaven. How do I get more popular and successful? We do have the perfect guest. You're listening to Lots More, where we catch up with friends about what's going on right now.

Because even when the odd lots is over, there's always lots more. And we really do have the perfect guest. Back with Jay Berry. He is now the head of global rate strategy at J.P. Morgan. The last time we had him on was in October of 2023, and the headline on the episode was like Jay Barry on the big sell-off in Bonds. And we can just recycle that headline. Yeah, call that again.

Would that the peak when we had them on then? I don't know. It might have been. Probably close, right? At the time, yeah. Jay, do you believe in the term premium? Well, Tracy, I think it's funny you talk about the last time I was on because 10-year yields are basically at the same level they were then. Yeah.

And at the time, the funds rate was 100 basis points higher than it is right now. So term premium is hard to measure, but I'm a simple man, and I think of it as the slope of the yield curve. And the slope of the yield curve is steeper for a given level. of policy rates. So I think it tells you that there is more term premium in the curve right now. Absolutely. Ira Jersey, who does rates here at Bloomberg intelligence, had a chart. And you just said, look, yes, one term premium, all that, but one part of the story is just that the market's estimate of the terminal rate is now higher than it would have been, say, six months ago, et cetera, at the start of the cutting process. And that a big part of the story with the rise in the long end since

September is just that, you know, there's not as much cutting baked in. I think that's exactly it as well. Joe, I think that's a really important point because this is now the middle ground. It's like part of it is the term premium and part of it is the terminal. If we get Joe to take the middle path, this is a success. I'm a middle of the road guy and I don't think a single explanation or a single factor can explain the bond sell off, but term premiums, one, Tracy, but Joe, Fed policy expectations matter because it's fascinating. Yeah. When the Fed cut 50 in September, we were pricing in a, you know, terminal funds rate of like two and three quarters. Yeah. And now we're pricing in a terminal

funds rate of 4%. It's a big change. It's a huge change and that's driven it as well. And it's so unusual. And I think it's unusual. But what the Fed did was unusual because basically by preemptively cutting 50, they said even though inflation hasn't come back to target, we do not want to sacrifice this expansion. And this probably means better growth to outturns in the future, higher inflation in the future, thus justifying fewer cuts down the road and actually higher rates. So that's a big piece of the puzzle because that's been a 125 basis point move as well. The one thing I would say, though, I mean, I agree. This is just me and Tracy debating through Jay. Obviously bond yields react to Fed expectations. You're the mediator. And the near term path of the economy and inflation. But

the one thing I would say is like in October, there were other things you could look at to measure nervousness about a potential Trump win like, you know, puts on the TLT that suggests. that a bunch of investors really wanted to shed long-term bond exposure right after the election. And this was happening like, you know, those were going up as Trump's polling odds were going up. So I feel like there are other things that suggest some of this nervousness is like secular in the long end. But anyway, the thing I wanted to ask, Jobs Day is coming up. So we're recording this on Thursday, January 9th. The bond market is actually off early today for Cardiff.

funeral, but how big a deal is the bond market reaction going to be to the jobs day? Like, if we're debating whether this is some secular, maybe politically related change versus something about the Fed and the path of the economy and inflation, it feels like jobs are going to be a big factor here. I think they absolutely are. And I think it depends on which part of the term structure you're talking about. Because what's been interesting in this move is that the front end has remained, Tracy, really well anchored, right? I think it's because the Fed has been been asymmetrically dovish in its reaction function. Right now, even with what happened in

December, with the dots showing only two cuts for next year, the Fed in aggregate is talking about cutting further, albeit at a slower pace, or just going on hold. Nowhere in the discussion is hikes. And that's why the money market curve, even though we're pricing in fewer eases, is still inverted. I think that could start to change if you see the labor market start to tighten again. So if the unemployment rate starts to come back down, that could be meaningful for repricing the front end in the opposite direction. But at the same time, even though the labor markets are not as weak as we perceive them to be back in August and September, there's been a steady slowing in private payroll growth. There's been a steady slight increase in the unemployment rate,

which tells you that the demand for labor is moderating. And if you get another sense of that tomorrow, and I think consensus is 160K with the unemployment rate at 4-2, we're 1504-2, so we're very close, I think that probably anchors the front end and tells you that it's probably, you know, relatively stable here. The long end is a different story. I think if the pace of employment growth is stable, but you see something like the rate come down and average hourly earnings firm back up, then the markets can price out a bit more of the Fed easing that we've got priced in, and it becomes a bit more of a parallel shift because that justifies higher long-term rates as well. So I think it's important with some asymmetry that the front end is better supported than the rest

of the curve, but this has been kind of our whole thesis too, and the employment data tomorrow is a key piece of that puzzle. The economy overall seems very noisy to me right now and hard to parse because there do seem to be signs like, look, growth continues, no real signs of slipping into recession. But on the other hand, there are signs that the labor market is softening, maybe the labor market is strengthening. I think it's actually really noisy. Let's zoom out, though, sort of big picture to talk about, I guess, since September.

What's happened? So there's been a few developments. First of all, just looking at the 10-year, you know, that bottomed at the, about 3.6 on September 16th. It's currently at 4.645 as of this second when we're talking at 801 a.m. January 9th, 2025. Since then, obviously, we did have the Trump win. We're not going into, there are still no signs of imminent recession. How would you tell the story, basically, of just what's happened, you know, and explain perhaps the upward repricing of that terminal rate since that initial 50 basis point? I'm glad you asked that.

And I think it's fascinating that that trough in yields was a day before the Fed meeting, right? So that was when we were priced for maximum dovishness. And at that point, we had seen the unemployment rate had been solidly ticking higher in the months before. And you could, maybe it turned out to be wrong, but you could at least tell a story then, oh, this looks like what happens before recession. Yeah, and it wasn't just the unemployment rate, because I think it's tough to disentangle what's happening with the rate, because there's obviously supply side factors going on there. But the pace of private payroll growth had to accelerate.

sharply as well. So that was a big one with what the July and August data showed. So I think since then, first, it's what the Fed did. When they went 50, I'm not going to sort of tutour own horn, but Mike Faroley, my colleague and our chief U.S. economists, I think it was one of the few calling for a 50. And I think that was a surprise at the markets because it showed the Fed's hand with respect to its reaction function. It really valued the labor markets over inflation and did not want to sacrifice this soft landing. And again, that generates better growth outturns and higher inflation in the few. which was a turnaround in rates because, perversely enough, it requires fewer eases down the road. So that's a big, dominant driver. And I think we can see that in the interim, since then,

to support this, growth expectations have moved up. And just for example, we've got our series of forecast revision indices and our year-ahead growth forecasts over the last three months have gone up something like a percentage point. And right, we've come off consecutive three percent quarters. It looks like we're running two and a half percent right now. So that's a piece of the puzzle. The second is, and this is where we'll get back to Tracy in term premium, is the change in the fiscal expectations because of the re-election of President-elect Trump. And that is meaningful because we expect the TCGA to basically be extended in full, and that's going to add an additional $4 trillion to deficits over the next decade on a baseline of what I believe was about $22 trillion

to begin with. And that matters because I think as we spoke about the last time we were here, the budget deficit running at 6 to 7% of GDP when we're close to full employment is highly unusual. And the growth of the Treasury market is just outstripping demand from its sort of most price-insensitive historical investors like the Fed and U.S. banks and foreign official investors. So we've got to find other price-sensitive investors to underwrite this supply. And when that happens, it just requires a higher term premium and higher yields and a steeper curve for a given level of policy rates.

So I think those are the few drivers there. and it's a global story. Yes, the U.S. has led away, but it's been happening everywhere as well. So back in October, I think it was October, you had a note where you sort of mentioned your former colleague, Josh Younger's famous Volfefefe Index. I think probably the only piece of J.P. Morgan Bond research to ever make it into New York magazines like Hot or Not graph at the end of the magazine. You remember that, Joe? Wait, did they still have that hot or not? if they do, but they did when it was first published. Yeah, I do remember that. That was a good. Valfefefe was hot. Yeah. The approval matrix is our producer dash reminds us. Yeah, that's right.

And you sort of, you mentioned it. Are you guys going to be reviving it under the Trump administration? So I can't comment on things that we intend to research, Tracy, but as you said, we talked about it a few times in the last few months. And I think it's important to understand that during the first Trump administration, that announcing policy via Twitter or via X right now. Or truth social. Or truth social, as the case may be, was something that did actually raise implied rate volatility and higher rate volatility necessitates higher term premium and thus more sticky higher rates. So it's something I think in the background that we're sort of focused on, and it's funny to talk about Josh. Actually, was on the phone with him yesterday. Oh, yeah. And so I think this is all kind of coming full circle. But I think that's something in the background that we need to

focus on as well, no doubt. Why is this a global story? I get the labor market looks stronger. perhaps than it did six months ago or five months ago or whatever. But a lot of headlines this week about the UK specifically. And now you have the global seat. I can ask you UK question. So why is this a global story and maybe tell something about the UK? Yeah. Thanks for that, Joe. But I think there's a policy story globally that's divergent, right? So the Fed and the U.S. is in a very different spot from rest of world. Euro area. ECB is cutting and cutting 25 until it goes into slightly accommodative territory, we think. So there's a slightly divergent factor there. B.OJ is in the midst of normalizing rates. Also, rates are going high in Japan. Where rates are going higher, exactly.

And then you ask about the UK. I think the UK is sort of stuck somewhere in between the US and the euro area because it's got the fiscal issues that we're talking about in the US. It's got the sticky inflation that we're talking about in the US, but it lacks the labor supply and productivity benefits that we've had in the US. So you've got a central bank that's kind of kind of getting stuck here and can only ease at a somewhat more gentle pace. And there's nothing really we can point to this week in the UK about the fiscal pressures. But they're just there in the background. And it's the same way the U.S. is sort of seeing this move to higher rate since we've walked into the new year that they're coming back in full force. So just to summarize the sort of

core tension, it has the same fiscal pressures as the U.S. but it doesn't have the same productivity growth as the U.S. Therefore, all that spending is running into a little. less productive economy, and that sort of creates that upward moving rates and the inflationary pressure and so far. Is that the idea here? It is to an extent. And I think it's also more idiosyncratic, Joe, as well, because look at what happened with the UK market. What was it back in September, October of 22 when the LDI sell-off happened. It's a market which, yes, it's smaller than the Treasury market, but it's less liquid. It's more concentrated in its ownership. So when you have a market where I think it's a bit more concentrated in its ownership than a very diffuse set of ownership

in the Treasury market, you can go through these balance of idiosyncrasy where it's hard to identify a single driving factor to see what happened with this sell-off, but it can get exaggerated by those factors as well. There is also a reflexivity at play here where if bond yields are going up, particularly at the long end when the U.S. is planning to do more long issuance, that means the cost of borrowing is going to go up, which maybe increases the fiscal burden and then yields go up even. further. Is that the kind of risk that we should be thinking about in 2025? I think it's a slow-moving train there, Tracy, because the average maturity of the U.S. Treasury market debt's about six years. So higher rates will definitely lead to higher interest expense and will add to the burden. But I think

a large part of that burden and that increase occurred as the Fed was raising rates rapidly. And we know that T-bills are about a 20 percent share of total debt outstanding. So there's a fair amount of short-term dead outstanding and it's less expensive than it was a year ago. So this will continue to feed through, but it will be at a very slow rate. So I think it's certainly there in the background as well, but not as primary or secondary driver as these other factors that we've been talking about. You know, speaking of policy by Twitter, I don't think that Kier-Starmer or what's the chancellor's name, Reeves, in the UK, they're not doing as much posting policy by Twitter, but the owner of Twitter is posting a lot about the UK these days.

So to the extent that there is just a lot of noise about the government going on, setting aside everything else, there is a lot of just political noise in the UK on top of all the sort of core economic stuff. And it's not just the UK, Joe. I think this fiscal noise is going on everywhere, right? We're talking about the TCGA and the fiscal burden in the U.S. You're talking about fiscal in the U.K. Look at what's happened with France, right? With its government falling. That's right.

And they've got deficit issues to try and get back out of the EDP over the next few years, which seems unlikely. You're talking about it in Japan as well. So fiscal and supply is, believe, a global story to varying degrees across developed markets right now. You need to do a Vol Elon index. That's right. Vol X. Oh, Vol X is good.

The Vol. Yeah, a global Vols. You can have that one. A global Volx index. They're just a measure of social media talk around the world relating to fiscal policy. That's a free one. That's great. You can't break it down by country there.

You do an ETF on that too. I'm going to trade vol. I'm going to trade volx. I like that idea. What about central bank like QT people? I don't know. People don't seem to talk about as much about QT. But what about the role of central bank asset purchases or selloffs in this story or on

wines? I think it's something in the back. round, right? I think back to 2018 when Shera Powell talked about QT and referred to it as watching paint dry. And I think it is just sort of going on in the background. And of course, in the U.S., it's at a slower rate than it has been for most of the last couple of years. But in our work, the Fed's balance sheet as a share of GDP matters for rate levels. It matters more for curve slope as well. So that's something that's happening in the background, because the Fed's balance sheet has been not only shrinking on a nominal basis, but shrinking relative to the size of the

economy, and we found that every one percentage point move relative to the size of the U.S. economy has been worth a handful of basis points on the yield curve. So as it continues to normalize, that is something that's in the background, also placing steepening pressure on the yield curve. And it's, of course, a global dynamic because you've got the ECB, the Bank of England, and now the Bank of Japan all doing this as well. And you can see it not just in curve slopes globally, but vis-à-vis swap spreads. I think there's been a story where swap spreads, until recently, have been narrowing globally across the DM as well. So you can see the imprint of QT there. It's there, but I think it's probably, again, kind of a third order factor when

considering the term structure of rates in the U.S. and globally as well. This might be a weird question, but since we brought up QT and earlier you were talking about the need to find new buyers for bonds, what exactly can the U.S. do if a bunch of traditional buyers like banks, the Fed for the past more than a decade, are stepping away from the market other than, you know, yields going up? Is there anything else they can do to market debt? to the outside world or, I don't know, even internally, have banks buy more bonds. So it's funny because the Treasury Department can only deal with the symptoms and not the root cause, but the Treasury and its sort of cadre of private sector advisors, the Teaback, have done a lot

of strong work on this. And there are charge questions that are asked at every single refunding process. And one that was asked of the Teaback a couple of quarters ago was, what new products and processes can we open up to sort of widen the spectrum of demand? I think they're asking this question, Tracy, for that very reason. And two products that were talked about were adding another floater at the short end of the curve. There's a lot of demand for short duration floating rate product that's latent. The other is adding another point on the tips curve. And the tips product has been around for close to 30 years right now, but we've only had three points on the yield curve. We've added three or four bill points. We've added three nominal points. So in order to make sure

that you're maintaining the tips product as a share of the treasury market and your commitment to it, you can add tips as well. So they're certainly focused on it. And that's, That's one way to try and widen the spectrum. The other, less from the Treasury, perhaps more from the regulatory side, is thinking about how you make it easier to intermediate in the Treasury market for banks and dealers and own Treasury. So there's been a lot of focus on potential regulatory developments in the context of Vice Chair Barr's announcement earlier this week. And I think that's something that we can think about in the background over the medium term, but would just offer that the timeline for regulatory reform is probably years to sort of unfold and not months. And

even when it occurs, I think some important points that we've made is that banks aren't leverage constrained right now. So bank demand for treasuries is not being constrained by leverage ratios. So it's something that could happen once again down the line, but it's not an issue right now. Do you have like a fair value here? So again, we're at like 4.64 or whatever. A lot of it seems to be explained by, you know, just the sort of overall change in the outlook since September. Then there's various reasons for volatility, maybe. Tracy would call it the term premium. But obviously, more issuance, uncertainty, higher deficits, etc. Where does that put us? Is it, are we around where it, quote, should be? Like, what

it makes sense to you or where could it go? And it's funny to draw the parallels again, Joe, because the last time I was on, we talked about this. And we made the case at that time that 10-year yields looked about 35 to 40 basis points too high relative to that fair value metric. Yeah. And that's adjusting for how the market's pricing, Fed policy, inflation, growth, within the size of the Fed's balance sheet. We're at a similarly high level right now, so the fair value would be probably closer to four and a quarter.

The only thing I'm going to sort of caveat there, and not to say that we're losing the anchor, that's an important valuation framework we have at JP Morgan, is that we've been trading either at fair value or cheap to fair value for the last two to three years. And I think it's because in the background, we don't have a term premium factor in that model, and we have to be sensitive to the fact

that that is something that's changing. So even though we're, call it two standard deviations cheap right now, my argument is that the propensity for mean perversion is probably lower than it's been in the past. Joe, are you a term premium convert yet? Yeah, sure, of course, sure. Say the sentence. Say the sentence, I believe in the term premium. You won't do it. Lots more is produced by Carmen Rodriguez and Dashel Bennett with help from Moses Andam and Kail Brooks.

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