Updated: 08-14-2017

Bad History Repeating Itself?
Updated: 09-Aug-17  03:58PM ET
Analyst: Pat O'Hare

Last week, former Federal Reserve Chairman Alan Greenspan said there was a bubble in bond prices.  This week, JPMorgan Chase CEO Jamie Dimon said he wouldn't buy a 10-year bond at this time from any country in the world; meanwhile, DoubleLine Capital CEO and Chief Investment Officer Jeffrey Gundlach said he thinks yields are going to break out to the upside and create market volatility as they do.

These gentlemen aren't the only bond market critics.  Plenty of other pundits have expressed similar concerns.  They could ultimately be proven right, but so far this year, the 10-year note has not followed suit with those bearish-minded perspectives.

More Drama Possible

There have been a few growls here and there, yet the price of a 10-year note is higher today than it was when the year began, which means its yield is lower than where it began the year -- by 20 basis points to be exact.

Various factors have contributed to the drop in yields, with fading inflation and inflation expectations at the top of the list.  There has also been some concern about the FOMC's inclination to remove policy accommodation and the possibility that the FOMC will tighten too much, too soon, and choke off recovery efforts.

At the same time, the dysfunction in Washington has reined in some of the lofty growth expectations seen at the start of the year since it has triggered doubts about the ability to pass tax reform aimed at driving stronger economic growth.

There are other contributing factors behind the drop in yield, yet one that may have been in the background -- and which may soon jump to the foreground -- is anxiousness about Congress authoring yet another debt ceiling drama.

Deja Vu

Treasury Secretary Mnuchin warned Congress in March that the U.S. was about to reach its legal borrowing limit and that the Treasury would have to resort to some extraordinary measures to temporarily prevent any default on U.S. obligations.

The hour glass on those extraordinary measures is running out, however, as the Congressional Budget Office (CBO) estimated the debt ceiling would be hit sometime in early to mid-October.

Congress will need to raise the debt ceiling to avoid a default.  In the past, that has been a routine order of business since Congress, by raising the debt ceiling, is basically agreeing to pay the expenses that it already approved.  

That business got unnecessarily disorderly in 2011, however, and prompted Standard & Poor's to downgrade the U.S. to 'AA+' in August 2011, shortly after a deal was worked out to raise the debt ceiling.

There has been some chatter in the background that raising the debt ceiling may not happen easily this time around either.  That's owed in part to the GOP infighting seen in the failed effort to repeal and replace the Affordable Care Act, and the outright partisan fighting between the Democrats and the GOP.

Press reports have suggested Republicans may not agree to raise the debt ceiling unless there are also provisions to rein in spending, whereas, Democrats are said to be reluctant to work with Republicans if they are under the impression that a debt ceiling increase would simply be a cover for Republicans to fund tax cuts for the wealthy.

Obviously, it would be a calamitous situation if the U.S. defaulted on its obligations, yet despite that ominous thought, investors are buying the 10-yr note, not selling it.  That is comparable to what happened in the battle leading up to the debt ceiling crisis of 2011.

It seemed counterintuitive, but in fact it was an intuitive move since it was assumed the U.S. debt would still be looked upon as a safe-haven in a world that might have to contend with a U.S. default.

The latter thinking rests on the understanding that global markets would likely go into a tailspin if the U.S. defaulted on its obligations and that Congress wouldn't take long to see the error of its ways and subsequently agree to raise the debt ceiling.  It calls to mind Winston Churchill's famous quote that, "You can always count on Americans to do the right thing - after they've tried everything else."

A Little Respect

Market participants are in a position again of having to respect the idea that the debt ceiling won't be raised without a contentious episode of partisan rancor.  That thought is lending an element of support to the 10-yr note.

The question is:  if Congress ultimately agrees to a debt ceiling increase, will that trigger some pent-up selling interest in the face of contentions that the bond market is a bubble or will yields still head lower as they did in 2011?

It would be reasonable to assume that yields would move higher as the safety trade unwinds, and since the European debt crisis isn't as troublesome as it was then, yet the expected path of inflation should be the ultimate driver.

If inflation picks up as Mr. Gundlach -- and the Fed -- think it might, then new worries are apt to surface, not about a ceiling of any kind, but rather about a long-term floor having been reached for the 10-year yield.

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