The Wall Street fund manager group is a special existence. They often comment on politics, question the economic policies of the President and the Treasury Department, and even tell the media directly which presidential candidate they support. These acts of “interference in politics” can be said to be commonplace, but there are more serious ones.
During this period, some people have already expressed their intention to “short” U.S. Treasury bonds.
On August 3, Bill Ackman, the founder of the well-known hedge fund Pershing Square Capital, publicly claimed that he was shorting the 30-year U.S. Treasury bond. As a result, Wall Street kept calm throughout August.
Bill Ackman is a strange man, with a boyish appearance and white hair, and he often speaks astonishingly. In recent years, he has entered the top 10 list of American hedge fund managers. As his performance fluctuates, his personal wealth has fluctuated between US$1 billion and US$5 billion.
Some people on Wall Street call him “Little Buffett,” but that’s not entirely accurate. His investment strategy is completely different from that of Buffett. He combines long and short positions, like a wolf, while Buffett is mainly long and is the market’s anchor.
A short seller is never a lone wolf, but a pack of wolves. If there is only one person shorting the market, then he will definitely lose money if he fights against the market alone. Only if his views conform to some hidden trends in the market, or trigger large-scale emotions, thus pushing the market to form a downward trend that is beneficial to short sellers, can he make a profit.
Therefore, there must be a profound reason why fund managers openly express the view of shorting long-term US Treasury bonds.
The logic of short selling
Bond prices and interest rates are closely related, and interest rate risk is also one of the core risks of bonds. Therefore, when observing the U.S. Treasury market, one should first closely track the interest rate environment in which it operates. This is also the reason why Wall Street fund managers want to “short” U.S. Treasury bonds.
Extending the timeline, starting from the financial tsunami in 2008, in order to save financial institutions and avoid the harm of deflation to the economy, the United States began to launch quantitative easing policies. The policy has lasted for more than 10 years and has had strong spillovers to global financial markets.
As the US dollar continues to export liquidity to the world, the global financial market has also entered an era of easing. For example, emerging countries such as Turkey have seized this time channel to borrow large amounts of foreign debt to develop their economies. Of course, it later took its toll.
However, with the rise of domestic inflation in the United States, this policy was almost ended by the Federal Reserve in 2020. At that time, the Federal Reserve began to reduce the scale of quantitative easing. However, due to the spread of the new crown epidemic in 2020, the Federal Reserve can only temporarily slow down the exit of quantitative easing. Entering 2022, austerity has finally begun.
Starting in 2022, the domestic inflation rate in the United States continues to reach new highs, once approaching double digits. As a result, the Federal Reserve decided to completely exit quantitative easing and raise interest rates to start a tightening cycle. In less than 18 months, the Fed has raised interest rates more than 10 times, something that has never happened in the last 30 years. The excessive speed of interest rate hikes indirectly triggered the bankruptcy of small and medium-sized banks such as Silicon Valley Bank.
Rising interest rates will inevitably have a direct impact on the bond market. Interest rates and bond prices have an inverse relationship. A rise in interest rates also means a fall in bond prices. The expected yield is the expected future interest rate, which reflects the price of a bond in the future. This relationship was most direct during the European debt crisis. At that time, the treasury bond yields of the “European Pig Five” countries continued to rise, which was reported in the newspapers every day. On the other hand, their treasury bonds continue to be bearish by the market, bond prices continue to fall, and some countries are simply preparing to default.
If the price of a bond falls in the future, it would be profitable to short it. This is the logic of Bill Ackman, who made this analysis on social media: “If the long-term inflation rate is 3% instead of 2%, and remains unchanged, then we may see 30-year Treasury bond yields Interest rate = 3% + 0.5% (actual interest rate) + 2% (term premium), or 5.5%, which may happen soon.” The
above analysis has been quoted by many financial media, and the logic is not complicated. He believes that the long-term inflation rate will be higher than market expectations because the Fed may not be able to suppress the long-term inflation rate. If it cannot suppress it, the long-term inflation rate will be as high as 3%, not 2% as some people think. The long-term inflation rate is one of the three factors in Treasury bond yields. Once the long-term inflation rate is higher, the expected yield on bonds will also be higher, and bond prices will fall.
There is a lot of resistance to raising taxes, so bond issuance has become the first choice. The U.S. Treasury Department is heavily borrowing, and international investors such as Japan, who hold large amounts of foreign exchange, have also entered the U.S. Treasury market.
In other words, short sellers of U.S. Treasury bonds are betting on an increase in long-term inflation, which means that the central bank will be unable to suppress long-term interest rates. In a sense, this is fund managers blatantly “singing against” the central bank or the Ministry of Finance. In many emerging economies, this kind of behavior is simply unthinkable.
Smart fund managers don’t necessarily have to tell everything they think. In addition to the yield factor, there are many reasons to be bearish on U.S. Treasuries. For example, the supply of U.S. Treasury bonds is simply too large. If the future supply is expected to accelerate or maintain growth, then the accumulated bond stock will also be considerable. When the supply of bonds increases, prices naturally fall. Financial instruments, like general commodities, comply with the principle of supply and demand.
The expansion of the U.S. national debt began with the Vietnam War. Huge war expenditures made the U.S. government financially stretched. For the government, there are only two ways to obtain funds, either raising taxes or issuing bonds. Due to the unique political system of the United States, tax hikes are highly resistant, so bond issuance has become the first choice. As a result, the U.S. government turned its attention to the bond market. The U.S. Treasury Department borrowed heavily, and international investors such as Japan, who held large amounts of foreign exchange, also entered the U.S. Treasury market.
The real rapid expansion of U.S. debt began in the 1990s. In 1990, the U.S. government debt stock was US$3.2 trillion, but by mid-2023, this number had reached US$32 trillion. In 2022, the GDP of the United States will be US$25.46 trillion, and the ratio of debt to GDP will reach 130%.
Why is the 1990s a critical juncture? Because during this period, the Soviet Union disintegrated, coupled with China’s accelerated reform and opening up, globalization swept all countries, and the international financial market also began to integrate. Due to the needs of international trade settlement and international capital flows, the US dollar began to export liquidity to the world. If the period is 30 years, then the US dollar has actually been in an easing cycle, and a loose environment is beneficial to bond issuers.
However, the easy dollar cycle is changing, and the external world facing bond issuers will also change.
The loose U.S. dollar cycle is the best time for U.S. debt issuers. The continued easing cycle will bring about a decline in U.S. dollar interest rates globally. For the U.S. government, the largest issuer of U.S. dollar bonds, the interest paid by it will also decline.
An interesting phenomenon is that in recent years, the U.S. government has continuously revised the debt ceiling, but every time there was a near miss. The main reason is that even though the stock of debt continues to rise, the decline in interest rates has effectively offset the impact of the rising stock of debt. Therefore, the U.S. government has the confidence to continuously raise the debt ceiling, while the payment of bond principal and interest can be sustained without large-scale defaults.
Mortgage interest rates are one indicator of the interest rate environment. In 1990, the interest rate on a 30-year mortgage in the United States was about 10%. By 2020, this number had dropped to about 3%. The sharp decline in overall social interest rates is undoubtedly a good thing for debtors. First, the interest paid to bond buyers on newly issued bonds must fall. Secondly, when interest rates fall, bond prices will rise, which will make bond issuance by financiers smoother and bond transactions more active. In short, everything is good for the debt issuer.
August 28, 2023, Wall Street, New York Stock Exchange
But as the Federal Reserve continues to raise interest rates, overall interest rates in the United States are rising. After 2022, the interest rate on 30-year mortgages once rose to more than 5%, sometimes exceeding 7%, which will undoubtedly affect the market’s expectations for long-term interest rates. As fund managers such as Bill Ackman believe, long-term inflation is expected to rise, which will lead to periodic changes in the interest rate environment.
Expectations of higher long-term inflation are not adequately explained in the simple mathematical formulas offered by fund managers. Behind it is a structural problem. To understand it, we must first clarify the reasons why the US dollar has been in a long-term easing channel over the past few decades, while inflation has been effectively suppressed by certain factors. So, what makes it so amazing?
The factors of economic globalization must not be underestimated, especially the rise of China’s manufacturing industry, which has provided ordinary Americans with high-quality and low-priced goods of all kinds, and has become one of the core driving forces for lowering inflation. The essence of inflation is “too much money, too few goods”, and China has solved the problem of “too few goods” for the United States. In 2019, the scale of Sino-US trade reached its peak, and China became the largest trading partner of the United States.
The fall in interest rates effectively offset the impact of rising debt stocks. Therefore, the U.S. government has the confidence to continuously raise the debt ceiling, while the payment of bond principal and interest can be sustained without large-scale defaults.
It is worth noting that the EU has always been an important trading partner of the United States, and was once the largest trading partner of the United States. The EU’s exports to the United States are mainly industrial intermediates, such as machinery and lathes, as well as automobiles, and chemical products. Whether they are relatively low-cost intermediate goods or final consumer goods, they are undoubtedly a useful force in reducing corporate costs and curbing inflation.
But things changed. The outbreak of global trade competition has had a profound impact on the manufacturing industry chain. In the process of reconfiguring the industrial chain, it is difficult for some international manufacturing capital to find an ideal place like China, and the production cost of global goods begins to rise. At the same time, in 2022, a war broke out in Eastern Europe and the international crude oil market fluctuated. Europe, which once enjoyed Russia’s cheap energy, is looking for new energy alternatives.
The changes have not stopped, but are still deepening and mutating. The kind of globalization based on economic interests that began in the 1990s stopped, and a new globalization began. The geographical layout of global production and trade of goods has undergone structural and irreversible changes. In many countries, including the United States, it is increasingly unclear whether the situation in which real wages are rising while goods are becoming cheaper can be sustained.
Structural changes in the global production chain are also the reason why the Federal Reserve has such difficulty controlling inflation. In 2018, Jerome Powell became chairman of the Federal Reserve and has been re-elected to this day. He has become the Fed chairman who has raised interest rates the most and most frequently since Paul Volcker. Paul Volcker served as chairman of the Federal Reserve from 1979 to 1987. He was known for his iron-fisted control of inflation and was called the “inflation fighter” by academics.
As of August 2023, U.S. inflation has still not been completely suppressed. The statement that some Wall Street fund managers are shorting U.S. debt has also become evidence that the market is still worried about long-term inflation.
However, shorting U.S. debt does not mean shorting the United States. Short-selling is betting on the price fluctuations of U.S. debt, not that U.S. debt will definitely default. Moreover, the fund manager’s short selling also uses options, which means that short selling is an option. Looking at it from another perspective, the high-profile short selling in the market just illustrates the size of the market, the active trading and the high degree of development. Otherwise, if there is a certain scale of short selling, practical operations will not be possible at all.
But no matter what, “short selling” has also released many bad signals, and it is indeed time for issuers of U.S. debt to reflect.