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The American economy is having a great summer, and in the hottest room of the house, the sun-filled kitchen, the air conditioner thermostat hangs and the oven is always set to broil.
The thermostat in this case is the bond market, which is seeking to offset soaring demand for debt from governments and businesses by raising borrowing costs to multi-year highs. The kitchen is the AI-building sector, desperately trying to put around $2 trillion in vast reserves of computing power by the end of next year.
Rising bond yields have little effect on slowing the pace of capital raising and corporate investment. But other parts of the economy, such as housing and Main Street spending, could cool too much.
Against this backdrop, Treasury Secretary Scott Bessent last week sought to rein in long-term Treasury yields by expanding an existing program to buy back small amounts of illiquid debt on the open market.
The move provoked a rather heated reaction from market participants and commentators as either a bad light for the Treasury Secretary, who accused his predecessor of misguiding market interest rates, or it was too small to matter, or both. Criticism intensified as the initial drop in yields was reversed the following day, while the US dollar continued to fall sharply and gold prices soared, a combination that could be interpreted as a vote of no confidence in the management of the monetary policy apparatus.
And, of course, the decline in bonds inevitably heightens fears that a long-threatened fiscal breakpoint could become a reality. Anxiety about America’s ability to finance its structural deficit is like an autoimmune disease. Anxiety often flares up under the stress of counterstimulus in the market, such as overheated capital spending or the feedback loop of war inflation, and then subsides again.
But would you be surprised to learn that the 10-year Treasury yield rose by just 4 basis points to 4.74% last week? Have yields risen here several times over the past three years, even if only temporarily? What about the fact that spreads on Treasuries are so tight that yields on investment grade corporate bonds remain below their peaks from a few years ago?
Absolute yield levels are not yet broadly demanding for large companies. Furthermore, so far there has not been a strong undertow pushing down stock prices. Given that the nominal GDP growth rate (real growth rate + inflation rate) is currently close to 5-6%, how much is the 10-year bond yield expected to fall? The steepness of the yield curve is similarly less extreme than historical ranges.
So why the fuss?
Due to the orderliness of past movements, the stock market is currently in a relatively difficult situation. Even if stock investors were to watch carefully, there is no clear standard for yields to immediately fall below stock prices.
The textbook notes that the high real yield cycle, in which the 30-year real yield, or nominal yield minus the market’s expected inflation rate, is currently above 3%, should be a drag on economic growth and stock valuations. Such effects may be subtle and long-term, but they are temporarily offset by promoting growth for the company in the moment.
It’s also important to realize that the S&P 500 index lives very comfortably in the same sweltering kitchen as its AI builders. About a third of recent revenue growth has come directly from AI infrastructure companies. It is really a benchmark among capital goods and businesses, rather than a measure of broad U.S. consumption. The consumer staples sector accounts for 9.2% of the S&P, but excluding AI/technology companies Amazon and Tesla, its weight is less than 4%.
So despite last week’s showing that housing starts fell 12.4% in July and Walmart posted its slowest quarterly same-store sales growth since 2020, the market remains within a few percentage points of its all-time high.
This does not suggest that the underlying economy is broadly struggling. Not at all. Consumer spending growth remains stable, unemployment is low, and the total consumer debt service burden is manageable.
But while wage growth has slowed, inflation remains high, tax refund windfalls are a thing of the past, and the real lifeblood of the economy remains in corporate spending driven by plentiful profits. Due to the power relationship between capital and labor, rising interest rates are seen by the public as a factor that worsens affordability, rather than a positive sign of strength in the household sector.
Is there a counter-trend rise in bonds?
For investors, an increase in the real yield embedded in a government bond means compensation paid to the debt owner, just as it increases the hurdle rate for the borrower. So, just as conventional wisdom goes against bonds’ role as a stock diversifier, do they store value?
Barry Knapp of Ironsides Macroeconomics said the recent rise in yields came in the face of inflation, slowing employment data and disparate consumer data. “While we remain long-term bond bears and don’t see the Treasury Secretary’s actions as a major positive catalyst, we still think long-term bonds have room for counter-trend upside.”
The S&P 500 fell 1.4% last week as the bond market dominated the headlines. Equity investors are focused on bond markets allocating capital through higher yields to the public and private sectors. What concerns equity players most is the voracious consumption and reckless deployment of capital for AI, which is now pushing up interest rates and potentially constraining growth in other areas.
Semiconductor stocks fell more than 5%, and although there was some glitch in the market’s clockwork rotation, the rebound stopped at a “logical” resistance level. Banks didn’t like the turmoil in the U.S. Treasury market, which fell 4%. Shadow AI’s expensive stocks, Industrial stocks, fell more than 3%. The S&P 500 itself retreated toward the upper end of its historical multi-month range, held from May to July, and has since rebounded modestly.
Rick Bensiner, now a veteran macro and technical strategist at Vensiner Investment Strategies, read from the tape and said technology has reached its relative peak and healthcare and financials are in a better position. He spies some technical warnings in this move. “The S&P 500 has had ‘closed’ candles for 10 of the past 13 sessions, suggesting that institutional investors have indeed been selling since the Aug. 4 top breakout date. If Nvidia (Wednesday’s results) does not bring in new buying material, I would really raise a red flag.”
market thermometer
This index from John Kolobos of Macro Risk Advisors uses several data points to reflect both what investors say and what they do.
Commenting on the latest data, Kolovos said, “The surge in sentiment partially explains this week’s drop in stocks. What is concerning is that while implied volatility remains low, we are starting to see more bullish responses in our sentiment survey. Despite my bullish forecast for the market, I have been advocating tactical VIX call spreads as insurance.”
around the street
— The Money Game, by a writer who published under Adam Smith, is rightly regarded as one of the best chronicles of Wall Street ever put to print. Introduced in 1968, it captures an earlier technology boom in the market, when mainframe computers (and space and defense technology) were exciting imaginations and driving valuations.
Today’s discussion of “circular financing” for customers’ technology purchases by major hardware manufacturers has echoes of this anecdote about a grizzled military veteran asking a “kid” investor how he made a 100x return in six months.
“Computer lease stocks, sir!” he said, like a cadet being questioned by an upperclassman. “The need for computers is virtually limitless,” said Billy the Kid. “Leasing has proven to be the only way to sell them, and computer companies themselves have no capital. So profits will increase 100% this year, double next year, and double again the year after. We’ve barely scratched the surface. The rise is just beginning.”
— The Wall Street Journal has a fascinating obituary for Victor Niederhoffer, the infamous trader who lived a vibrant life and died earlier this month.
When I was writing columns for the magazine, Niederhoffer would email me from time to time, usually with condescending backhanded compliments that suggested one of my articles meant I “almost got it.”
His most scathing disdain was towards my then-colleague Alan Abelson. He was a longtime chief columnist and former Barron’s editor known for his intelligence, literary talent, and tenacious, bearish demeanor. Vic compared Alan to “a priest who doesn’t believe in God, a stock market writer who hates the stock market.”
Vic never hated the market, but the market didn’t always love him back. He made and lost two fortunes and blew up the market by effectively shorting volatility before it crashed.
market is closed
Earnings growth has outpaced stock price gains in recent quarters, allowing bullish voices to praise the cheap shot at valuation compression.
This is true when you look at the standard price-to-earnings ratio, which has fallen from 23x to 20x over the past 10 months. But as we know, the biggest earners are reinvesting furiously to fund AI ramp-up. Along with memory chips and gas turbines, what’s currently in short supply is free cash flow.
Here, the S&P 500 price-to-free cash flow ratio using projected FCF is just below 30, the highest level in decades.
To put this another way, the free cash flow yield for 10-year government bonds is 4.74%, while the free cash flow yield for stocks is 3.4%.
Of course, corporate cash burn is primarily a choice, but big tech platforms are not acting as if they see plausible options for participating in the arms race toward superintelligence. Or at least to have enough data center capacity to lend to those looking to create a new collective consciousness from silicon.
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