Playing Defense

Welcome to the first weekend of NFL football which means the summer is over and a seasonally weak time of year for the stock market. Lots happened over the past few months as oil prices rose, interest rates increased and the hope of a soft landing faded. And don’t forget about the euphoria around artificial intelligence and forging through a banking crisis in the Springtime. However, the one new item added to the list is that the US Treasury Department upsized the size of their forthcoming auctions over the summer as the Federal Government is running a massive deficit (roughly 6% of GDP) and that will pressure interest rates higher in the coming months.

There are several Trillion dollars of government debt that are up for maturity over the next year and they will be refinanced at much higher cost to taxpayers. If you look at the adjacent chart, the interest expense is skyrocketing and this will continue for many years. This will contribute to the deficit and further pressure 10Yr interest rates higher.

Over the last decade, the Fed has funded the deficit which was called “monetizing debt” or printing money (if the deficit was $600B, the Fed bought $600B in Treasury bonds). This kept a lid on longer term rates during this period but now that the Fed is downsizing their balance sheet (quantitative tightening) this leaves the Treasury department fully exposed to the market’s price discovery mechanism. Not to mention, overseas holders of Treasury bonds (China, Japan & Europe) are reducing their US dollar holdings to offset the strong dollar.

The US Yield Curve

You can see below that longer tenor bonds are rising in yield as natural buyers of US Treasury bonds are becoming scarcer. And the longer the deficit lasts the more bonds that will need to be issued unless Congress raises taxes or reduces the footprint of government spending. However, a split government means that type of change will not be on the table until after the next Presidential election (2025).

Corporate Bonds

Higher interest costs also have the potential to eat into earnings – especially for below investment grade companies. As you can see in the chart to the right, interest costs are the highest since the financial crisis.

Fortunately, bond issuance was healthy this past week as investors return from vacation. Several companies cleared almost $50B of investment grade bonds at an average rate of 5.7%. Perhaps, these issuers sense the brewing risk of higher rates and want to lock-in at these levels before the yield curve adjusts to a higher for longer environment.

The S&P 500

The tide seems to have turned this past week on stocks. The catalyst is likely concerns on 10Yr yields and the price of oil spiking this past week due to a restrictive policy decision by OPEC. If correct, then a re-test of support at the August high (‘B’) at $432 or lower is likely this month.

Pressure is building on the Fed to tap the brakes on rate hikes as the lagged effect of such a sharp increase looks to be on the horizon for the bond market. It is good that labor markets continue to be strong but higher wages increases for 2025 may also mean a reduction in headcount for many companies. Inflation numbers are next week, BTW!

Have a great weekend!

Paul J McCarthy III CFA

President, Kisco Capital

Paul McCarthy

Mr. McCarthy is the President and founder of Kisco Capital.