The US may be entering an era of higher yields but the rest of the world isn’t

It’s almost too frightening to contemplate what might be happening in the bond market. If the latest move up in Treasury yields is really about debt, deficits and an oversupply of bonds then god help us because the pain of getting it all back into order will be brutal.

That’s not what I think it is, at least not yet.

The message the bond market is sending is that the US economy can sustain 5% rates. Previously, the believe was that the Fed might tag 5% and then cut rates aggressively six months later in a bring them back to the 2-3% range, depending on the severity of the fallout.

If the US can sustain 5% rates, then we’re simply not going back to that world. Instead, we could be in a 3-6% world in the US and in that world, you need to be compensated more richly to own long-term bonds.

To me, that adds up.

USA versus the world

Where it gets more interesting is in the rest of the world. I haven’t seen any evidence that the rest of the world is tolerating 5% rates, or even the 4.50% in the eurozone. Cracks are clearly visible and rates will come down next year. That’s particularly true in the places that experienced the worst real estate bubbles.

So you have the US that’s in a 3-6% regime and the rest of the world in a 1-4% regime (and Japan stuck in a black hole).

That’s divergence and it’s exactly the kind of thing that drives long and lasting FX moves. During covid, all global interest rates reset but now we’re moving away from that era to one of rate differentials. The Fed funds market is still pricing in 64 bps in Fed cuts next year and that’s starting to look like a long shot, especially if the manufacturing recession comes to an end.

So what does it mean?

I have been repeatedly astounded by the raucousness of the US dollar bears. I just don’t see it. The trend is your friend and the trend is a higher US dollar. Long term trends in the FX market also rarely end with a whimper; and instead end in a crescendo.