Clean Up on the Treasury Desk
Higher real rates, but far from a crisis. The House made 1BBBA marginally better, but spending is still too high. The Fed is behind the curve, asset allocation changes.
Note: This is a longer than typical note, but we added more pictures (charts). Enjoy your holiday weekend and God Bless those who gave their life to protect the Constitution of Liberty.
Hold Your Horses Cassandra
One of the dynamics of ‘25, no doubt a result of a President determined to make consequential changes to trade, tax, spending, and regulatory policy, who doesn’t seem to sleep or take any days off, is significant market moves that would typically persist for a quarter or more are happening in 1-2 weeks. We made a forecast in late February that slowing growth in 1H25 would lead to a 10-12% pullback in equities and 50bp drop in 10-year Treasury yields, the Treasury move took 2 weeks, the stock decline took 4. An even more draconian policy change caused even larger corrections over 6 weeks, we expected the process to stretch over most of the first half. Two weeks ago, we suggested the markets would turn their attention from the trade to the budget deficit, and the bond market was likely to correct, and once again we were surprised by the velocity and magnitude of the correction. Underlying the high velocity policy driven market moves is instability in cross asset correlations, most notably stock bond correlation and the role of bonds as volatility reducing ballast in the benchmark 60/40 portfolio.
Just as we finalized last week’s note, Moody’s became the final of the three rating agencies to downgrade the US credit rating, a sign our fiscal concerns were consensus. Late Wednesday night the House finalized and advanced 1BBBA (One Big Beautiful Bill Act, we kid you not, that is the official name). Thursday began with 30-year TIPS, one of the indicators we cited last week as a sign of supply driven stress, breaking above the all-time high yield of 2.70% and quickly spiking to 2.80%. The 10 & 30-year swap spread inversion approached the Trump Trade Shock levels, mortgages widened, the 10-year term premium widened to 92bp, up from -25bp when the FOMC began the recalibration rate cuts in September ‘24. The bond market rout was global, JGBs, Bunds and Gilts were all under pressure, the equity market got caught in the vortex, but for no particular reason (macro data or policy catalyst), the bond market stabilized early Thursday morning. On Friday morning with the budget battle on hold with Congress on recess until early June, the President was back in trade shock mode with threats targeting Apple and the EU, and Treasuries resumed their more traditional role as a diversification asset for equity portfolios. The belly of the curve led the bounce, even as Treasury prepared to auction $183 billion of 2s, 5s and 7s next week.
While we have been in the bond bear camp since we made our call in August ‘20 that the 39-year bond bull market was over, a trend that persisted throughout our entire career on Wall Street to that point, for reasons we explain in the next session of this week’s note, we expect the Treasury market to stabilize. We do not think current levels are sufficiently attractive to increase exposure to fixed income, consequently we remain underweight. 1BBBA was the best opportunity to unwind the Biden Budget Blowout, the D’s called this Build Back Better, we think our name better captures the impact of Secretary Yellen’s modern supply side economics. As we detailed last week, the spending cuts, even with the Freedom Caucus changes including the tightening of work requirements on Medicaid, reverse less than 20% of the spending gap above the 50-year 20.3% of GDP median.
One important point of differentiation of our view relative to the Cassandra vigilantes is our view that tax policy has a far smaller impact on deficits than CBO/JCT scoring suggests. The tax policy changes are likely to improve the mix of growth we called Cleaning Up the Industrial Policy Mess and Treasury Secretary Bessent characterized as a detox from the addiction to government spending. Consequently, the House achieving their aggressive deadline by passing the 1BBBA before the Memorial Day recession, and the easing of the Trump Trade Shock evident in the rebound in May regional Fed manufacturing surveys 6-month forward capital spending plans, increases our confidence in our forecast for a strong 2H25 capex recovery. Capex strengthening is critical to offsetting the drag on consumption from the import tax.
The last three months have been a wild ride, but tax, spending, regulatory and trade policies are about where we expected when we made our forecast for a decent year for equities (10%) with 10-year Treasury yields ending the year higher (4.5%). In this week’s note we will discuss the implications of 1BBBA on the Treasury and equity markets, our case for the FOMC providing relief to the small business sector by restarting the easing process. We finish the note with some sector and asset allocation changes.
