Have you heard?

Have you noticed what’s been happening in U.S. bond and equity markets?

Why are short term bond yields and equities down, and why are long term bond yields mooning?

Well, the outcome is all quite rational even if the reasons are irrational, but it’s a tale of these two curves 👇👇👇 with today’s steepener curve in red, and the 5 December 2024 yield curve in blue.

Why 5 December? Since that day, the 10 year yield has dis-inverted over the 2-year curve, and the back end started to steepen aggressively—for all the wrong reasons, ahem, Mr. Powell...

First, take a look at the curves below, which I have defaced with comments in the margins and some numbers to indicate the term premia being built into 10-year and 20-year Treasuries.

So, what can this tell us about markets and the future?

The short end of the curve and equities

Simply put, the very short end (1 to 3 months) indicates a pause, and even as far out as 1 year suggests no levity above the bottom of the current Federal Funds Rate (FFR) range of 4.25% to 4.5%. This is different to what commentators have been telling you and the equities market has been hoping for—that the Fed will continue to cut. Up until now, the market has been way ahead of itself, expecting massive interest rate cuts and therefore, investing like there’s no tomorrow and pushing up equity valuations—because future cash flows are discounted less, the lower interest rates go.

So, today, as we see more downward recalibrations in equites, it’s a direct result of the strong employment numbers and the fact that the U.S. economy is the envy of the world and steaming ahead.

Given the very strong non-farm payrolls well above the neutral employment rate and sticky core PCE. there is now a 97.3% probability of a rate pause on the 29th of January.

‘Pause’ means ‘no cut’. And ‘no cut’ means bad news for those holding overvalued equities on the expectation of cuts.

The long end and term premia

The long end of the curve is a different story. It’s driven by inflation expectations.

And as I’ve indicated in the chart commentary above, bond holders are telling the Fed that they think the Fed is ‘taking the piss’.

Wait what? Yup, they’re selling bonds because they don’t believe the Powell Fed is serious about reigning in inflation. They know the Fed has never been truly independent and that the last cut, at least, was a political move.

It’s simple, if Fed Chair Powell is not serious about stamping out inflation, the long end is not interested in parking money in U.S. bonds—at least not at low yields.

Consequently, long end rates are steepening as per the red curve (compared to where it was on the blue curve) as investors demand higher term premia to buy the long bond, i.e., 10 years plus.

Why is that? Well, they are demanding compensation for the purchasing power they will lose on their fixed income coupons as they get ready for higher inflation for a lot longer, that might trend even higher under Trump2.0 tarifflation.

And it’s about time because for far too long, there has been no term premium (financial incentive) to hold long bonds.

Term premia are starting to normalise, higher.

What now?

At the long end, it is likely we will see further steepening and higher long yields.

If we get a fully normalised yield curve, we could see term premia of 150 to 200 basis points, meaning the 10-year could conceivably hit 5.8% to 6.3%. And the 20-year? Way over 6%.

I’m not saying it will get there, as the 2-year yield will likely adjust down over time, and if we get the pause on the 29th as well as some hawkish comments at the Presser after the FFR decision, the back end of the curve might settle a little if traders think Powell cares more about inflation than his job. Maybe not.

But higher rates for longer for the wrong reasons (fighting recurring inflation which I’ve warned often comes in waves) are negative for equities and for bonds. And there is also a scenario where they could literally skyrocket under an unhinged tariff and sanctions policy—but calculating probabilities for that is way beyond my pay grade and I don’t have.

It’s still not time to buy the U.S. long bond. There’s no insurance in the long bond. It’s got more to go and will reward those who are patient, sometime in the future.

And make no mistake, Dollar Vader will be stronger for longer.

So, from a corporate development perspective, higher rates and a higher USD is bad for input costs and your cost of capital, i.e., the discount rate you’re using to assess projects and/or acquisitions—as it goes up, it makes deals harder to bank, fund and get over the line.

Final thoughts

Summing it all up in an open letter to the Fed Chair?

“Hey Jay, you’d better get a handle on inflation yesterday and don’t even think about cutting interest rates—coz there’s no reason other than for politics to do it. And if you’re going to ‘take the piss’ because you care more about your job than inflation, we’ll continue to dump bonds and demand higher fixed coupons to compensate for the future inflation you’re going to cause by flaking out on inflation that’s NOT transitory—especially as tariffs and more rate rises in Japan (that will suck money out of U.S. markets) are about to make things a lot harder for you. Time to go to work, for real. Disaffectionately yours, but not for much longer, the Bond Market.”

See you in the market.

Mike