Bonds squeeze Main Street as Wall Street waits on Warsh — Analysis

There’s something telling in how the smart money on Wall Street has started to think about socialism. The moral of the story isn’t really about socialism, though, but about the very real pain in store for American households from the bond market if the actually-in-charge capitalists don’t get their act together. 

The idea is that socialists are on the rise, but the problem will be self-correcting because the national debt is so crushing it will force whoever’s on top to deal with it.

“A democratic socialist, motivated by hatred of inequality, may be just determined enough to stake his or her political career on the idea that America can finally stomach some tax hikes,” write Matt Gertken and Yushu Ma, analysts at research firm BCA, in a recent client note. 

Whether that is true about socialism — who knows? 

But the bond market is already becoming a check on Americans’ livelihoods, with the capitalists firmly in charge. A sell-off in recent days has been triggered by an unlucky confluence of events and egged on, perhaps inadvertently, by the new Federal Reserve chairman, Kevin Warsh. That points to the conclusion that the pain for Main Street is likely to remain intense for the foreseeable future, even as Wall Street continues to prosper. 

Bond traders have spent the summer selling off long-term U.S. government debt, resulting in a sharp steepening of the yield curve. The short end of the curve tends to follow the Federal Reserve’s policy rate, while the long end reflects bets on growth and inflation. And while the Fed hasn’t budged under Warsh, the market’s view about the long end has gotten a lot more muddled lately.

The spread between 2-year and 10-year Treasuries has grown by nearly 29 basis points since June 24, according to FactSet data, a large gain in a short period. (One basis point equals 0.01%.) That was driven primarily by an increase in the 10-year, which traded above 4.7% on Tuesday. 

Yields near 5% tend to provoke angst on Wall Street, because they allow investors to earn an alternative robust, risk-free return. Still, a sell-off would have to be deep to reset the economy’s winners and losers. The S&P 500 has returned a cumulative 77% over the past three years, according to FactSet data. Stock holdings are concentrated among the wealthiest Americans.

Meanwhile, Treasury yields are dragging on Main Street. A swath of consumer debt is heavily influenced by the 10-year yield, including mortgages. A 30-year mortgage will now cost a typical purchaser 6.75%.

Frustrated home-buyers who want to know why buying is so tough won’t find an easy answer. 

The clearest trigger for the run-up in bond yields has been the Iran war. Oil is only trickling out of the Middle East, and U.S. refineries are running near maximum capacity. A gallon of diesel cost $5.46 on Tuesday, up 48% from a year ago, according to AAA data. 

Add to the mix what seems to be an insatiable demand for debt by tech companies to build data centers and other infrastructure for artificial intelligence. That competes with government bonds for investors’ interest. 

Economists can argue about how to weigh these and other factors. But finger-pointing about exactly what triggered the sell-off “misses the point in my opinion,” writes Robin Brooks, senior fellow for economic studies at the centrist think tank the Brookings Institution, in a newsletter Tuesday. 

“When you have a lot of debt and run unsustainably large budget deficits, you’re extremely vulnerable to any old shock that comes along. It’s not about the shock, but – instead – the mess we are making of fiscal policy on a global scale,” Brooks writes.

He is looking at global markets, but there is little dispute that the U.S. is a mess. 

The U.S. budget deficit is set to come in at around 6.4% of gross domestic product, based on the Congressional Budget Office’s recent estimate that the deficit will hit $2.1 trillion for the fiscal year through September. 

The Trump administration has said that some of the increase in spending is due to the one-time military necessity of the Iran war, and that lower-income households have seen wage increases recently. But it has no obvious plan to cut deficits. 

Warsh, the new Fed chairman, has expressed some sympathy for regular Americans battered by high interest rates. His view is that financial conditions are restrictive on Main Street — particularly in housing — but clearly loose on Wall Street. 

The question now is whether Warsh will do anything about it. 

Warsh in July seemed to welcome the rise in bond yields, noting that they have risen in real and nominal terms while the Fed kept its rates steady. “At some level, we haven’t done much in 42 days. The markets have done quite a bit,” Warsh said.

Warsh’s seeming acceptance of higher rates prompted traders to push rates still higher. 

He has also argued that the Fed helped juice Wall Street by putting trillions of dollars worth of Treasurys and mortgage securities on its balance sheet in the years since the financial crisis. But he is yet to convince the rest of the Fed to go along with reversing that, and in the short term, a reduction in the Fed’s balance-sheet holdings would put more upward pressure on long-term treasuries and mortgages.

Warsh will have an opportunity to nudge the market in a new direction, if he so chooses, when he takes the stage at a closely watched central bankers’ conference in Jackson Hole, Wyo., on Aug. 28. He is likely to talk about the state of the economy and how he sees the relationship between the bond market and the Fed. His views on the balance sheet will likely have to wait until a Fed task force on that issue reports back in a few months.

Warsh’s views in Jackson Hole may help to stem the bond-market selloff and ease the pain on Main Street. But one speech can only do so much, and the Fed can’t do anything directly about the balance of government spending and revenue. 

That, of course, is why Wall Street is thinking ahead. At some point, the bond sell-off will likely hit a point where prices are so attractive that investors will swoop in and start buying again. When the buyers come back, yields will fall. Markets have been through this cycle repeatedly in recent years, with the 10-year yield edging up toward 5%, threatening stocks, and then tumbling back down again. 

That cycle may not add up to a financial crisis. But unless it eases, it will almost certainly fuel a continuing, slow-burn political crisis.

If capitalists don’t seize their moment, the socialists will.