The recent rise in long-term U.S. Treasury yields has captured the attention of financial markets, a phenomenon dubbed the "Bondcano" due to its significant impact on global financial dynamics. This surge, notably highlighted by the 10-year Treasury yield, often regarded as the anchor for global asset pricing, has raised concerns among investors and economists alike. As yields increase, the adverse effect on bond prices becomes evident, leading to a ripple effect across various financial instruments and markets.

The relationship between bond prices and yields is an inverse one; thus, as the yield rises, bond prices fall. This situation has not only affected Treasury securities but has also initiated a broader decline in the value of financial assets worldwide. A notable consequence is the strengthening of the U.S. dollar, as capital flows back into the American economy, causing liquidity to dry up and negatively impacting stock markets. Emerging markets, which typically thrive on foreign dollar reserves, are witnessing a retreat as the influx of dollars reverses course back to the U.S.

Current statistics reveal a staggering increase of over 500 basis points in the Federal Funds rate and the two-year Treasury yield within a span of two years. The latter now sits above 5.15%, the highest level observed since June 2007. There is no sign of this upward trend abating, with the 10-year Treasury yield also on the rise, having exceeded 300 basis points to reach levels around 4.5%. The question arises: Why is this happening, and why is it expected to continue in this trajectory?

One of the primary catalysts behind the inevitable rise in long-term Treasury yields is the alarming rate of U.S. government deficits, which exemplify a systemic flaw within the economic framework. Treasury bonds essentially act as an extension of a nation's savings. In the aftermath of World War II, the U.S. dollar was established as the global reserve currency, imbuing Treasury securities with a characteristic of an international public good. Consequently, central banks around the world have accumulated U.S. dollars and invested in Treasuries, thereby integrating them into the global savings apparatus, boosting the demand for liquidity and security.

To sustain the international demand for the dollar, the U.S. must consistently run trade deficits, which in turn necessitates ongoing fiscal deficits to provide Treasuries as a solution for liquidity needs. Failure to do so would undermine the dollar's attractiveness and cause a scarcity of global safe assets, posing a risk of deflationary pressures worldwide. Nonetheless, this trade-off comes with its own set of challenges; the scale of trade and fiscal deficits must remain manageable. If these deficits spiral out of control as a percentage of GDP, it could jeopardize the backing value of the dollar and Treasuries, leading to rampant inflation and a loss of their safe-haven appeal.

The U.S. has chosen to maintain its posture of "trade deficits and fiscal shortfalls," accepting a controlled depreciation of the dollar and a simultaneous increase in the volume of Treasuries issued. The repeated raising of the debt ceiling has resulted in a growing national debt, leading to the second factor driving up long-term Treasury yields: an oversupply relative to demand. Following the 2008 financial crisis, the supply of Treasuries skyrocketed. As of September 19, 2023, total U.S. debt surpassed an eye-watering $33 trillion, tripling from 2009 levels. However, foreign central banks are increasingly unable to absorb this debt.

The Federal Reserve's efforts to reduce its balance sheet imply that it will no longer be a purchaser of Treasuries, which poses a challenge for new Treasury debt that will solely rely on domestic investors. Unfortunately, domestic demand (from banks and shadow banks) has its limits. Following a crisis in March of this year, banks significantly reduced their holdings of Treasury securities, offloading around $250 billion worth. This context means that in order for the U.S. government to sell Treasuries, yields must rise to attract buyers. Higher yields, however, force the government to pay more interest, further worsening the fiscal deficit in a self-perpetuating cycle.

In terms of the structure of U.S. debt, the government cannot solely issue short-term bonds, particularly given the high costs associated with them amid a yield curve inversion. A substantial issuance of long-term bonds becomes imperative. Bloomberg's projections indicate that in the latter half of the year, long- and medium-term bonds may increase by $600 billion, while short-term bonds could grow by $200 billion—and this trend is anticipated to continue into 2024 with a staggering net increase of $1.7 trillion in long- and medium-term bonds.

The repercussions of this "Bondcano" eruption could shake the foundations of the financial market profoundly. U.S. government bonds, particularly in the medium to long-term, are viewed as hidden assets by money market funds. These funds leverage Treasuries to obtain collateral for repurchase agreements, further intertwining themselves within these securities. As Treasuries yields rise, the resultant effects primarily manifest as risks concentrating on money market funds, which inevitably transfer these risks to asset management firms.

A wave of rising interest rates on long-term Treasuries threatens to erode the equity of money market funds and jeopardize the foundations of the shadow banking system. Conventional banks in the U.S. hold substantial positions in Treasuries, suggesting a systemic risk should asset losses accumulate. The broader implications of increased long-term rates will be catastrophic, casting a long shadow over stock markets and investors.

An example of the brewing turmoil is the hedge fund strategies focusing on basis arbitrage, exploiting price differences between Treasury futures and the cash market. This highly leveraged strategy is becoming riskier amidst the dramatic surge in U.S. Treasury yields. Major financial institutions, including the Bank for International Settlements and the Federal Reserve, have sounded the alarm bells on these practices.

Still, the rising long-term yields show no signs of stopping; the "Bondcano" remains active, spewing lava in the form of escalating rates. The root causes behind these increasing yields have not been resolved, and concerning news continues to emerge that pushes rates even higher. The government's deficit is spiraling, nationwide strikes are escalating (notably among automotive workers), the federal student loan repayment moratorium has ended, oil prices remain elevated, and inflation is making an unwelcome return. Each of these variables has direct implications on the U.S. economy, which inevitably reverberates through to Treasury yields.

Months ago, billionaire hedge fund manager Bill Ackman, once vocal about shorting U.S. Treasuries, revised his forecast stating, "I believe long-term yields, such as the 30-year, will continue to rise." He underscored that the structural features of today's economy differ markedly from the past: diminishing peace dividends, reduced deflationary effects from outsourcing production to China, and a growing influence wielded by labor and unions. With successful strikes yielding significant pay increases, the likelihood of more strikes is on the rise. Energy prices are surging, and neglecting to replenish the strategic petroleum reserve represents a grave oversight. Amidst OPEC and Russia's production cuts, the U.S. must act decisively.

Gary Dugan, CEO of the Global CIO Office, emphasizes that both the U.S. and global economies are grappling with a perplexing reality where strong economic growth coincides with persistent inflation. Although markets are clinging to hopes of declining interest rates, the rebound in economic activity coupled with improved unemployment metrics leaves the Federal Reserve with limited maneuverability. Recently, the Fed reiterated its stance, indicating that additional rate hikes are not off the table for the year, and that elevated interest rates will persist for an extended period.

Investors appear trapped within the confines of a persistent inflation outlook, yet the Federal Reserve remains acutely aware of the situation and continues to enforce measures aimed at curbing inflation. While inflation may eventually ease, its trajectory remains uncertain, as highlighted by the erratic predictions made over the past two years. "We must prepare for the possibility that the 10-year Treasury yield could reach 5%," cautions financial analysts.

With the current 10-year Treasury yield hovering around 4.56%, this marks new highs unseen since October 2007. Jamie Dimon, CEO of JPMorgan, starkly warned in a recent interview with a major newspaper that the worst-case scenario for the Fed's benchmark rate could escalate to 7%, leading to stagnation. He elaborated on the comparative pain levels of moving from 5% to 7% against lower increases, noting, "I’m not sure the world is ready for a 7% environment."

In conclusion, if the benchmark rate ascends to 7%, it is highly likely that the 10-year Treasury yield will breach the 6% mark. This precarious situation calls for vigilance among investors and policymakers alike, as the ramifications of these changes in terminal rates can reverberate throughout both the U.S. and global economic landscape.