Why Bond Markets Are Sending a Warning Signal

Vincent O’Neill: Welcome to SB Talks. Today is Thursday, September 10th. I am Vincent O’Neill. I’m joined, as ever, by our Chief Investment Officer, Nick Ryder. Welcome back, Nick, from a trip to the US. We’ll be looking forward to your insights from stateside.

Today, Nick and I will be discussing why soaring US government debt and rising bond yields are forcing investors to reassess their positions in the markets, whether stubborn Australian inflation, stronger economic growth, and cautious RBA commentary mean another rate rise is locked in, and how equity markets can tell you their resilience despite these pressures.

Welcome to all our listeners.

Let’s begin in the United States. Government debt has now crossed over that $40 trillion threshold, with, fair to say, no political will on either side of the aisle in the US to get the deficit under control.

I guess a couple of key questions: How are we now seeing this play out in the bond markets, particularly with the long bonds? And how concerned should investors be?

Nick Ryder: Yeah, I mean, it’s amazing that just 10 years ago it was $20 trillion. Crossed through $20 trillion.

Vincent O’Neill: Mm.

Nick Ryder: We’re now crossing through $40 trillion. Obviously, we had COVID, et cetera, but we also had a lot of tax cuts.

Vincent O’Neill: Yes.

Nick Ryder: Particularly from the Trump administration. So the deficit is $2 trillion a year, 6.5% of GDP, and that’s in an economy that’s booming.

Yeah. So normally…

Vincent O’Neill: With theoretically full employment.

Nick Ryder: Full employment. So normally that’d be the opportune time to rein in deficits, but no. So look, really, there’s not a lot of political will on either side.

The spending is non-discretionary, so it’s Medicare and Social Security and things like that.

Vincent O’Neill: They’re hard to remove from a system once they’re deep within it.

Nick Ryder: That’s right.

Vincent O’Neill: Despite DOGE’s best efforts, I should say.

Nick Ryder: Yeah. DOGE didn’t really do much. And of course, the interest bill keeps mounting. That’s now more than defence. It’s about a trillion dollars a year.

So yeah, very, very difficult. I mean, there are some people saying that these Medicare and Social Security funds will actually become bankrupt in 2032, and that may force some sort of bipartisan effort to rein it all in. But until then, it’s very hard to see how that changes.

So I think this is something that markets are going to have to get used to. We do see them sort of get a little bit excited about it every six to 12 months and then kind of forget about it.

Vincent O’Neill: But the broader trend is definitely the bond market increasingly, I guess, pricing in more risk.

Nick Ryder: Yeah. And for long bonds, for 10, 20, 30-year bonds, investors are demanding a higher term premium to lend to the US government for that period of time.

It’s not that anyone thinks the US government’s going to go bust. That’s not likely to happen. But they’re just demanding a higher premium.

Vincent O’Neill: There’s a higher risk involved.

Nick Ryder: Because there is a higher risk involved. And it’s not just that. You know, there’s just the sheer amount of bonds being issued every year.

But there’s also the AI hyperscalers that have a trillion dollars of funding that they’re trying to raise. A lot of that will be borrowed. So they’re now competing with the corporate sector.

Vincent O’Neill: Which has seen…

Nick Ryder: For issuance.

Vincent O’Neill: Scott Bessent has got onto his platform and is getting out there talking about the role that the government might play, or the Fed might play, around bond markets and talking down the long bonds, if you will.

Nick Ryder: Yeah. So they have increased what they call these Treasury buybacks. So they have this program where they allocate some money to buy back older bonds that are maybe less liquid and replace them with fresher bonds that are on the run. And so they’re trying to use that as a bit of market manipulation.

And we saw another attempt at that overnight where they announced they were going to do $6 billion of buybacks of 10 to 30-year Treasuries. That’s trying to put a bit of a cap on the yield, and it didn’t work. So the yield actually rose five basis points for the 10-year.

And the market was a bit underwhelmed. I mean, six…

Vincent O’Neill: Six billion. You have to look at the scale of the market. The beast is probably too big to control.

Nick Ryder: Well, we just mentioned it’s $40 trillion, and there’s $6 billion. It’s not really going to make a difference.

Vincent O’Neill: And the deficit running at that level.

Nick Ryder: So Bessent’s trying to talk down yields and say, “Oh look, we’re here to kind of support them at certain levels,” but ultimately the market is more fundamentally focused. So deficits and debt are ultimately what will drive it.

I mean, it’s not just about concerns over the US government debt trajectory. The economy’s actually doing well. And in that scenario, where you’ve got an economy doing well, a lot of issuance from the government and from the corporate sector, inflation is still a problem.

So there’s a whole bunch of reasons why yields…

Vincent O’Neill: A recipe of risk.

Nick Ryder: Yields should probably be higher.

And then, of course, concerns over Fed independence, and particularly Kevin Warsh. Will he really be there to tackle inflation? So all of these things sort of go into the mixing pot as to why yields have been gradually climbing higher.

I should put it in context. Yields are really only back to where they were pre-GFC. You know? And so in some ways, the post-GFC period of zero rates and very low interest rates, that was unusual.

So now you could almost argue, okay, yields are 4% or 5%. That’s pretty normal.

Vincent O’Neill: If you put a line through the last 20 years and say that was the artificial period, we’re probably just back to more normal pricing of risk.

Nick Ryder: That’s right. Five percent yields weren’t that big a deal back in the pre-global financial crisis era.

Vincent O’Neill: And the Japanese yen got wheeled back into the conversation, and Scott Bessent has got involved in that.

Nick Ryder: Well, it’s part of the same thing. Because they’re worried that Japan, who owns $1.1 trillion in US Treasuries, is the largest foreign holder of US Treasuries.

The US Treasury doesn’t want the Bank of Japan selling those to try and support the yen.

Vincent O’Neill: Support the yen.

Nick Ryder: So the yen has weakened by about 45% over the past five years. It’s very undervalued. And so Bessent’s out there trying to talk up the yen and say, “Well, I’m working with the Bank of Japan and the Ministry of Finance, and I’ve got asymmetric information.”

And I think he said, “I am the house now,” was his expression.

But also daring traders to take on the might of the US Treasury and the Bank of Japan.

Vincent O’Neill: Careful what you wish for.

Nick Ryder: Yeah. I mean, it’s worked a little bit.

So the yen has strengthened. I think it’s around 153. It got out to 163 not that long ago. So it has strengthened.

But it’s part of the whole thing to kind of keep a lid on US borrowing costs.

Vincent O’Neill: And in that same recipe, we talked inflation before. We know conflict in Iran is far from resolved and has probably moved backwards in recent times, and that is reflected in the oil price.

Nick Ryder: So we’ve got the oil price back above $100 for Brent. It’s the highest it’s been since late July. It was $80 a month ago.

I think I mentioned on this podcast before that we were sort of stuck in that $70 to $100 range where, if it got down too low, the Iranians would start rattling the sabre and launching a few missiles. I think we’re seeing a bit of that, particularly as we head into this period before the midterms.

They want to try and use as much leverage as possible because I think they’re seeing their window of opportunity diminish.

There have been reports that the US has been helping tankers get through at midnight.

Vincent O’Neill: Clearing mines in the middle of the night.

Nick Ryder: Yeah. They’ve been getting these boats out in the middle of the night with their transponders turned off and all this sort of stuff.

Vincent O’Neill: As well as countries finding other routes to move their oil out of the region. Pipelines, things of that nature.

Nick Ryder: That’s right. Some is moving by land through to the Mediterranean.

There’s pipelines through to the Red Sea and through Oman. So oil’s been getting out.

And so I guess it plays into this whole thing that they’re trying to shake things up. They’ve launched a couple of missile strikes with these new high-tech missiles that dodge interceptors.

They’ve launched those at some naval ships and then the US has retaliated with attacks on Iranian tankers.

Vincent O’Neill: So you talked there before about that critical window of $70 to $100 a barrel, and we’re certainly at the north end of that and through it now.

That is the point where the trickle-through impact on inflation is material and has a lot of central banks pretty worried.

Nick Ryder: Yeah, and it’s not just the crude oil price because we know the refiners have been charging a lot to turn crude into diesel, gasoline and jet fuel as well.

So yeah, it just plays into this whole issue around inflation.

So it will be interesting to see what the Fed does next week when it meets.

Vincent O’Neill: How’s the market pricing?

Nick Ryder: We’re looking at around 66% currently for…

Vincent O’Neill: Likelihood of a raise?

Nick Ryder: For a hike, yeah.

We did get Kevin Warsh presenting at the Jackson Hole Economic Symposium last week, and he was quite hawkish.

He was saying, “We’re still focused on inflation. Two percent target. We’ve got work to do.”

Yes, there’s been some improvement in inflation over the past few months, but it’s not trending towards where we want it to be.

So potentially there could be a rate rise from the Fed next week. Certainly, we knew from the previous meeting there were three dissenters.

Vincent O’Neill: The momentum is more in that direction since then.

Nick Ryder: Yeah, and we got a strong non-farm payrolls report on Friday. 162,000 jobs created and upward revisions to the prior couple of months.

So they can’t say, “Oh, the labour market’s weakening and that’s why we need to keep rates on hold.” That line of argument has gone because of the strength of the labour market and the economy more broadly.

Vincent O’Neill: Turning closer to home in Australia, inflation for July was stronger than expected, and GDP growth also surprised somewhat on the upside.

The case for an RBA hike has certainly strengthened.

Nick Ryder: Yeah, definitely. Those two things, plus some commentary from RBA officials in recent days, have also pushed pricing.

Vincent O’Neill: Reinforced the messaging.

Nick Ryder: Yeah. So we’re sitting at almost an 80% chance of a hike at the end of the month.

As you said, we got July inflation data. The trimmed mean stayed at 3.6%, roughly where it’s been for the last three months. Certainly no evidence of it trending back down.

Vincent O’Neill: Back to where they’d want it to be.

Nick Ryder: And if you look in the data, and this is something that Sarah Hunter, Assistant Governor at the RBA, said, market services, rent and dwelling construction are all domestically generated sources of inflation that remain a bit high.

Vincent O’Neill: Mm-hmm.

Nick Ryder: So definitely something they’re watching.

And also GDP came in a little bit stronger than market expectations and the RBA expected. So 2.1% year-on-year growth in Q2, or 0.4% for the quarter.

But if you look through the details, discretionary consumer spending was quite strong.

Some of that might be Iran related. There was quite a lot of demand for new motor vehicles, particularly EVs. There was probably less international travel because of oil prices, and AI investment and all those sorts of things.

So the RBA is looking at those two data reports.

And we had Andrew Hauser, who’s a Deputy Governor, on the 7:30 Report saying, questioning whether we’ve done enough or if more is needed.

He said inflation for July was a little stronger than expected and GDP was also a bit stronger.

He spoke about upside risks to inflation from the Iran conflict, obviously with the oil price higher.

He spoke about the weak productivity growth in the GDP numbers, which I think were negative or very low. So there’s no new supply being created in the economy.

And he had just got back from Texas, where he’d become even more concerned that the AI data centre investment boom was creating demand for workers and resources.

Vincent O’Neill: Various pressures.

Nick Ryder: Cost pressures.

Vincent O’Neill: Cost pressures.

Nick Ryder: On the economy and creating cost pressures.

Those three things. Quite unusual for him to go onto a current affairs show.

Vincent O’Neill: To get on message.

Nick Ryder: Yeah. So potentially softening the market up for a rate rise.

Vincent O’Neill: I think it’s fair to say that the market has well and truly softened up at this point, given where it’s sitting on expectations for a domestic rate hike.

Nick Ryder: Yes. As I said, 78% chance for the 29th of September meeting and 91% by the end of the year.

Vincent O’Neill: One hike.

Nick Ryder: Yeah.

But a lot of economists, a lot of the bank economists that had said, “Oh no, they’re done.”

Vincent O’Neill: They’ve changed their positions.

Nick Ryder: Well, they’ve all changed their tune.

Vincent O’Neill: I think Westpac was the last one to eventually come into line.

Amidst all these factors, if we paused the conversation here, someone who didn’t know how equity markets were travelling might say, “Well, it’s going to be a pretty choppy year. Conflict in Iran, inflationary pressures, rate hikes.”

Yet the equity market has shown reasonable resilience over the course of the year.

We’ve just finished the Aussie reporting season, which at the headline level fared reasonably well, but perhaps was a little more mixed or subdued under the surface.

I guess that’s a specific comment, but also to the markets more broadly.

Nick Ryder: Yeah. The backdrop for equities is pretty good.

You’ve got a global economy that’s weathering the Iran conflict and last year’s tariffs.

The global economy is growing pretty strongly. The US is going well, partly helped by some of the tax cuts that I mentioned.

Vincent O’Neill: AI investment boom.

Nick Ryder: AI investment, corporate earnings.

We’ve spoken on the podcast before about Q2 earnings. They’re up 50% year on year.

Energy, materials, consumer discretionary and IT, not just AI. So a lot of companies are doing well.

Same in Europe, actually. Europe had a very good earnings season.

Australia wasn’t bad either.

So yes, tick for a lot of the underlying drivers of equity earnings.

And yes, bond yields have climbed a little bit higher, but I think those two things can coexist. You can have higher bond yields if the economy is doing well, and higher equities.

At some point, if bond yields climb too high and interest rates get too high, the equity market won’t like that. But at the moment, it’s okay.

Vincent O’Neill: I think higher bond yields bring more rational thinking to an equity market.

Nick Ryder: Yeah.

Vincent O’Neill: When we had negligible or zero bond yields, if you were a company that generated not a lot of cash flow or no profit, but had some longer runway to get there, markets would be more forgiving.

Now, when the cost of capital is higher and it’s not coming down, I think we all agree on that, markets are less forgiving and place much more scrutiny on free cash flow, profits and earnings.

That’s a healthy thing.

Nick Ryder: Absolutely.

Vincent O’Neill: More rationality to the market.

Nick Ryder: I think the other thing that’s good and has happened over the past few months is that some of the speculative excesses, the chip stocks, the Korean stock market, the meme stocks and the momentum stocks, a lot of that has unwound.

So the market’s consolidated a little bit.

There’s more focus on underlying earnings. Are these companies actually doing well? Do they have profits that are growing? Et cetera.

Vincent O’Neill: That’s healthy as well. It’s how you would hope a rational market would operate.

And with your Chief Investment Officer hat on, you look at all these different pieces and how you put them together. Anything that’s particularly catching your eye or that looks attractive to you?

Nick Ryder: Yeah. When we look at the rise in bond yields, people say, “Oh, I don’t want to own bonds.”

But you look at a 10-year inflation-linked government bond in Australia now and it has a yield of almost 2.9%.

Vincent O’Neill: Mm.

Nick Ryder: So you can give the money to the government, they’ll give you 2.9% every year plus whatever CPI happens to be.

So if it’s 3% or 4%, they’ll give you that as well.

And that’s actually pretty attractive. That’s the highest it’s been for a long time.

For a lot of clients, they’re building portfolios that try to get CPI plus 3. You can get that from government bonds. You don’t even need to go into equities to get that.

So that’s just something we’re looking at. We think that’s actually pretty attractive.

Bonds still do have a role.

Vincent O’Neill: Have a role to play in portfolios, despite some of the challenges of recent times.

And quite interestingly, you’re sitting down and beginning work on your strategic asset allocation review, so that is timely.

Nick Ryder: Definitely.

Vincent O’Neill: Well, welcome back, Nick.

Nick Ryder: Thank you.

Vincent O’Neill: And thank you to all our listeners.