In recent times, we have witnessed an extraordinary surge in the yields of U.STreasury bonds, particularly that of the 10-year Treasury note, which has been dubbed the "Bondcano" due to its explosive increaseThis situation has sent ripples throughout the global financial markets, drawing attention to the fundamental dynamics of U.Sdebt and its implicationsAs the yield climbs, it sends a clear signal: the price of Treasury bonds is falling, leading to a cascade of effects on various financial assets around the world.

The surge in Treasury yields correlates inversely with bond prices; thus, as the yields rise, the value of existing bonds decreasesThis phenomenon is not merely a problem isolated to the bond market; it has broader implicationsFor instance, the U.Sdollar has strengthened, liquidity across markets has contracted, and U.Sstock indices have shown declines as investor sentiment grows cautious

Emerging markets are also feeling the heat, with U.Sdollars being repatriated back to the States, creating a ripple effect on global liquidity.

Recent statistics provide a clearer picture: over the past two years, the Federal Funds rate and the yield on 2-year Treasury notes have surged by over 500 basis points (BP), with the latter now exceeding 5.15%, marking its highest level since June 2007. At the same time, the 10-year Treasury yield has also increased significantly, climbing over 300 BP to reach approximately 4.5%. And there seems to be no sign of this upward trend abating any time soon.

At a mid-year analysis conference held on July 15, we predicted that long-term U.STreasury yields were destined to riseThe question many might ask is: why is this an inevitable scenario? What factors are contributing to this 'Bondcano' effect?

The crux of the issue resides in the massive budget deficits incurred by the U.S

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governmentThis problem is systemic in natureNational debt, fundamentally, is an extension of a country’s savingsPost-World War II, the U.Sdollar ascended to the status of the world’s primary reserve currencyAs a result, U.STreasury bonds acquired characteristics akin to an international public good, with central banks around the world accumulating dollar reserves and investing in U.SdebtConsequently, these bonds became a crucial vehicle for global savings, with demand arising from needs for liquidity and safety.

The U.Seconomy must continuously provide dollars through trade deficits and finance long-term budget deficits via Treasury bonds to fulfill global liquidity needsFailing to do so risks diminishing the allure of the dollar, which would lead to a shortage of global safe assets, triggering deflationary pressures worldwideHowever, there exists a delicate balancing act: if trade deficits and budget deficits expand beyond a manageable threshold as a percentage of GDP, it can undermine the intrinsic value backing the dollar and Treasury, potentially leading to rampant inflation and a loss of the dollar's safe-haven appeal.

The stance taken by the United States has been to maintain this trade and fiscal imbalance, allowing for a controlled devaluation of the dollar while continuing to expand the scale of Treasury issuance

This policy of increasing the "debt ceiling" has led to an inevitable rise in long-term Treasury yields due to the dynamics of supply and demand.

After the 2008 financial crisis, the supply of Treasuries escalated significantlyAs of September 19, 2023, the total debt exceeded a staggering $33 trillion, approximately three times the total debt seen in 2009. Notably, foreign central banks have reached a saturation point and are no longer able to absorb additional U.SdebtSimultaneously, the Federal Reserve is shrinking its balance sheet, further reducing demand.

Consequently, the onus to purchase new Treasuries has shifted predominantly to domestic investors like American banks and shadow banksHowever, this demand isn't infinite; after the crisis in March, banks significantly reduced their holdings of Treasury assets by $250 billionSuch circumstances imply that for the price of Treasuries to stabilize, yields must climb, thereby attracting potential buyers back to the market.

In an environment embroiled in economic stagnation, the government's approach to stimulating the economy mandates increased investments and subsidies, which invariably lead to further fiscal deficits

To offload Treasury bonds, the government must elevate interest ratesHowever, rising rates imply higher interest payments, which in turn escalates the fiscal shortfall, setting off a vicious cycle.

The structure of U.Sdebt also plays a contributing factor, as the government cannot solely issue short-term debtIn fact, especially under conditions of inverted yield curves, short-term debt becomes excessively costlyThus, there is a fundamental requirement for ample issuance of long-term Treasury bonds, which are projected to net an increase of $600 billion in the latter half of the year, while short-term notes may add around $200 billion, with long-term bonds expected to rocket by $1.7 trillion in 2024.

The ongoing eruptions from the U.STreasury volcano will inevitably have repercussions throughout the financial realmU.STreasury, particularly medium to long-term bonds often represent invisible assets for money market funds

These funds indirectly hold medium to long-term U.Sdebt and utilize Treasury collateral to engage in repurchase agreements with market makersAs yields for U.STreasuries rise, the risks are exacerbated for these funds, which eventually pass the risk onto asset management companies.

The explosive rise in Treasury yields will decimate the financial fabric of money market funds, draining their resources while also causing significant losses in shadow bankingSimilarly, traditional banks holding substantial amounts of medium to long-term bonds will face painful asset depreciation.

No one, it seems, is immune to the impact of rising Treasury rates—certainly not the stock market! For example, last week’s discussions highlighted that hedge funds utilizing high leverage for basis arbitrage trades between U.STreasury futures and cash bonds are increasingly exposed to danger, particularly as this 'Bondcano' continues to unleash its effects.

As we delve deeper, we notice that the fundamental issues behind climbing long-term Treasury yields remain unresolved, with alarming news propelling yields even higher

The scale of government deficits is expanding rapidly, coupled with nationwide strikes (like the ongoing auto worker strikes), the conclusion of federal student loan repayment pauses, persistent high energy prices, and a resurgence of inflationary pressuresThese factors directly affect the U.Seconomic landscape and will subsequently alter the rates of U.STreasury bonds, particularly long-term ones.

A few months ago, billionaire hedge fund founder Bill Ackman, who boldly declared a short position against U.STreasuries, now contemplates that long-term rates—such as those on 30-year bonds—will likely continue their upward trajectoryHis reasoning rests on the belief that the current global economic structure diverges from the past in significant waysThe so-called 'peace dividend' has been fading, the long-term deflationary impacts of outsourcing to China are diminishing, and the bargaining power of labor unions and workers is steadily increasing

This shift is evident in the frequency of strikes, where successful wage negotiations lead to an escalating likelihood of further labor actions, in addition to rapidly rising energy costs.

As we face these challenges, Gary Dugan, the chief executive officer of Global CIO Office, suggests that both the U.Sand the world at large are awakening to a bewildering reality: the economy appears to be experiencing robust growth alongside persistent inflationAlthough there is hope for interest rates to fall, the Federal Reserve's room for maneuvering seems increasingly constrained amidst an improving economy and declining unemployment ratesJust last week, the Fed reiterated that further rate hikes this year should not be ruled out, and elevated rates would be maintained for an extended period.

Investor sentiment has entered a cycle of adaptation amidst ongoing inflationary concerns, yet the Fed remains preoccupied with controlling inflation, implementing measures to address rising costs

Although we may eventually see a decline in inflation, the market's ability to accurately predict its trajectory has proven to be erratic over the past two years.

As the narrative unfolds, we must brace ourselves for the possibility that the yield on 10-year U.STreasury bonds could approach 5%. Currently, this yield hovers around 4.56%, marking its highest point since October 2007. Jamie Dimon, the CEO of JPMorgan Chase, recently weighed in on the Federal Reserve's benchmark interest rates, noting that the worst-case scenario could see rates reaching 7%, coupled with stagnationHe expressed that an increase of 200 basis points from 5% to 7% would be far more painful than a rise from 3% to 5%. He noted, “From 0% to 2%, it’s almost like no rate increase at all; from 0% to 5% catches many off guard, yet no one doubts that 5% is possible.” He concluded with uncertainty over whether the global economy is prepared for rates reaching 7%.

Should benchmark rates indeed rise to 7%, the yield on the 10-year Treasury could very well leap towards 6%.