The Fed Can Pause. Bonds Still Have a 5% Problem

Index-level volatility remains in line with what the daily VIX would suggest, a gauge I broke down in the latest weekly plan post.

What it means is less of a need to hedge your positions or actively expect a sudden volatility breakout.

That’s also why the put/call ratio in the indexes, like the NASDAQ above, are so low as to say markets have zero intention of hedging their long exposure in the tech index.

While it seems market mechanics would be right to understate the need to hedge, we also know that these extremes in complacency tend to lead to a sudden shift of behavior and events.

We now have a few triggers on the table:

As expectations shift around the market’s future path, volatility will have to adjust as well.

That drives us into a very specific scenario, one where any outcome outside of these new expectations will significantly change the relationship in expected volatility and realized volatility.

Why does this matter to you?

Because no matter what the Fed does this week, the market still has a 5% yield problem at the 10-year.

So today, I want to break down what actually drives this yield, and whether it is something the Fed can fix.

Otherwise, Warsh may have effectively lost control of the bond market, and the vigilantes are out to put a stop to the AI debt issuance excess.

Click here to read about the Yen Carry Trade and how that may keep bond yields higher by itself.

From July to present day, the U.S. 10-year bond yield has moved from ~4.5% to a current ~4.95%.

Like everything else in markets, the headline move matters very little compared to what the move was actually made up of.

For these bonds specifically, the waterfall of components goes like this:

The Fed can directly, and indirectly, control all of these to some extent through monetary policy and the dual mandate.

However,

Past that control, market forces come into the mix as traders begin to price in their own set of opinions and expectations around these components.

And that is why I believe the Fed has currently lost control of the bond market, even if Warsh hikes this week (or pauses), policy path is now the weakest driver in the past quarter’s move.

Policy path made up 10bps of the total 45bp move (or ~22%.)

Now we break down the other two and what they mean for the market during this week’s Fed decision.

Excluding COVID, PCE inflation (the Fed’s preferred gauge) is now the highest its been since the 2008 financial crisis.

While there are a lot of nuances this time around stemming from the Iran war and energy supply shortages, there are also some repeatable instances akin to those of previous euphoric market cycles.

Such as the ones caused by the housing run in 2004-2007.

These are, of course, showing up through the AI buildout with the typical second-order effects.

As property and financial asset prices continue to remain elevated, those with a financial position (the top % of households) will carry the spending and revolving credit as if nothing was going wrong for the rest of the U.S. households.

Let’s break that down:

The gasoline boost in inflation is self-explanatory from the Iran war and not related to everything else I want to point out today.

Shelter and core services are what I want to focus on right now.

As I mentioned, property and rental prices are elevated despite rising mortgage rates and most would-be homebuyers being priced out of the market today.

Thus, the top % of households show up in that print, singlehandedly carrying the majority of the housing market on their shoulders.

Another driver of shelter inflation can be traced to the data center buildout wave, as construction resources and available space get reduced from the unprecedented pace of expansion seen in the space.

As a result, core services have also driven a lot of the latest CPI print.

Think electricity, internet, phone bills, insurance, and healthcare.

Some related to AI (like electricity and bandwidth), some related to the inflation expectations created by AI (like healthcare and insurance.)

The point now is that there is a feedback loop between AI demand and inflation.

Meaning,

As long as the AI race keeps up its current pace, I don’t believe the inflation component of the 10-year will subside.

Like a lot of financial market data, term premiums are another measure reaching back to 2008 crisis levels.

This one is subsequently the biggest driver behind the move from ~4.5% to ~4.95% over the past quarter.

In fact, over 51% of the bond’s move can be explained by these premiums.

Which is exactly what matters to market participants and those trying to figure out what to do after the Fed’s decision this week.

Because even if rates are held (no hikes), and inflation eases on an energy supply chain normalization…

Term premiums remain in charge, and there’s a very specific reason for that.

Let’s begin with the national debt spiral and the handful of fiscal promises that have gone unfulfilled.

Political opinions aside.

Trump’s tariffs were designed to bring in a trade surplus, aimed at easing both the debt and interest payment load on the nation.

The original idea has gone far off course.

Middle East conflicts and involvement with the Ukrainian front prompted another debt wave for defense purposes, amplifying the negative effects caused by a failure to ease the debt and interest payload.

Among other events, there are the most recent ones being:

All of these items are working their way to the national debt, and thus interest expenditures.

Right now, the U.S. government pays more in interest than the national defense budget.

Each time this has happened in history, a major war breaks out to justify a rebalance that looks like:

Whether we see a major war or not is up to debate, but that’s been the historical playbook.

A less speculative item can be seen in the relationship between interest expenditures and corporate profits.

And today, we’re back at the upper historical range.

Knowing that both fiscal uncertainty and economic stability are present, it makes sense that bond investors want to receive additional compensation for investing in the asset class.

No matter what the Fed does on Wednesday, recall policy path only made up 10bp of the 45bp move over the past quarter.

Inflation, while more pronounced than the rate path, is still relatively insignificant as a driver to the 10-year yields right now given that the reason behind inflation is known at this point.

Term premiums, driving over 51% of the 10-year’s move, remain the tail risk.

As uncertainty around interest, corporate profits, and failed attempts to balance our deficits continue…

I suspect these premiums will not only hold but potentially widen in the coming months.

Unless something changes.

Interestingly enough, I believe ending the AI mania will fix most of these issues from the inside out.

Fix inflation, fix corporate profit disconnects, fix yield spillover from rising corporate bond risks.

As a result, this also likely ends up with an equity market drawdown, further prompting a flight to bond safety.

Click here to refresh your view on other bond market drivers.

All of what’s been said today leads me to think of the TLT ETF as a massively coiled spring.

Traders have already put on a bull spread here it seems.

On a ~2:1 ratio, the current TLT options setup looks like this:

A one-directional trade for pure upside is being made for the entirety of 2027, financed entirely by quarterly short put rolls on a ~2:1 ratio of long/short.

In other words,

If these traders are right, they are singlehandedly calling for the demise of the AI financing complex, a market drawdown, and a return to bond safety.

Based on what’s been covered today…

I cannot disagree,

Now $80.85.

Covering that topic in depth will be my target for the week.

Meanwhile, here’s the latest from Jordi Visser as the retail authority on AI.

Once again, his posts are now sounding a lot more abstract and narrative based compared to earlier this year when real numbers were on the table.

This says a lot about where the AI trade is currently headed:

Until next time,

OFFSIDE RESEARCH

Against the Tape, Ahead of the Curve.