As we head into the last weekend of September, investors have plenty to be a little anxious about. The deadline for a U.S. government shutdown is midnight on Saturday and we still have seen little breakthrough on the autoworkers strike.  To cap it off, bond markets around the world are under pressure, even though fundamentals haven’t really shifted since the start of summer. Analysts and economists have shifted away from the recession camp, yet markets are behaving as though few have any real conviction for that view. Not exactly the way we want to close the books on the third quarter.

 

 

As we set up for the coming months, let’s start with Washington. Since 1990, there have been six federal government shutdowns, ranging from 3 days to as long as 35.  In 1990, under the George Bush Sr. administration, the government was closed from October 6^th to 8^th.  Ironically, this was the only time that there was a shutdown with Democrats controlling the House. In November 1995, the government was shut for five days in November and then 21 days from December 16^th to January 6^th, 1996. Ten years ago, a shutdown lasted from October 1^st to the 17^th. While this was third longest shutdown in this period and also the third most expensive in terms of the cost to government ($2.1 billion). We had another three-day shutdown in January 2018, but the longest on record took place between December 22, 2018, and January 25, 2019. By the end of the standoff, 380,000 employees had been impacted and the total cost was roughly $5 billion.

 

 

 

Some have posited that if a shutdown were to emerge from this weekend, it will likely be a protracted one and potentially match the one from 2018-19. The basis for this call is that it is not just typical partisan quibbling that is driving Washington to the wire, but fractures in the Republican party and those are seen to be unresolvable in the near-term. If it were to extend, then we would expect to see a very different labour market picture develop in October. The pace of net job growth has already decelerated with the 3-month average for monthly non-farm payrolls increases fell to 150,000 in August and, outside of the pandemic distortion, this is the weakest since 2019. If businesses respond proactively to what they see as a deterioration in job growth and incomes, then this could set us up an even weaker picture through the fourth quarter.

 

 

Unfortunately, looking back at past shutdowns doesn’t really give us a clear sense as to what to expect in terms of equity or bond performance. For example, if we examine the 1995-96 episode, there had been a strong advance in the S&P500 through most of 1995, but we got consolidation when the shutdown hit. A pullback lasted only until January 10^th (a few days after the end of the shutdown), after which the market rebounded. Bonds rallied right through the shutdown, but keep in mind that the Federal Reserve was also cutting rates.

 

 

 

The last shutdown was interesting though. Similar to today, the S&P500 was already in retracement mode heading into the shutdown. Back then it was off 19% from its September high into the start of the shutdown. At the low this week, the index was down about 8%. Even though the shutdown continued into January, the S&P bounced strongly and kept rallying through much of the first half 2019. The 10yr U.S. treasury yield was ascending alongside Fed tightening and hit a peak of 3.2% at the start of November. That year, the Fed decided to pause in November and then hiked once more in December, in contrast to the pause we just saw this month and the expectation of a move higher at the upcoming November FOMC. Yet, the smell of economic weakness was in the air and the bond market rallied all the way through the shutdown, with the 10yr yield falling to below 2.6% in December (even with the additional rate hike). Bonds would continue to rally for the first three quarters of 2019 as economic growth stalled. Of course, this doesn’t mean the same is going to happen this time around, but I think the odds of a similar pattern are increasing.

 

 

 

As much as the shutdown and the auto strike continued to grab headlines this past week, the big story was the sell-off in bonds and how the 10yr U.S. yield broke above 4.5% and reached its highest level since 2007. The noise we heard in the last few days wasn’t crickets, but the sound of head scratching. It wasn’t like we received bad news on inflation or evidence of stronger economic activity. The revisions to second quarter U.S. GDP were actually softer than expected and the core PCE index was in line with economist calls. New and pending home sales in the U.S. dropped sharply in August and consumer confidence declined in September.

 

 

Some have commented that forced selling is behind the latest move higher in yields.  This would be similar to stop-losses being triggered on a stock, where continued declines in the price of a bond push it below a threshold where the investor wants to unload and limit further losses. There has also been speculation that U.S. banks with still sizable government bond exposure on their balance sheets are remembering back to the Spring and trying to limit additional shrinkage.

 

 

These may indeed be true, but this has been a global sell-off this week. The Government of Canada 10yr yield has pushed above 4% and even countries that not too long ago flirted with negative yields, have seen an appreciable rise in yields. Germany’s 10yr benchmark bond is a hair away from 3%, where it was in minus territory at the start of 2022. Japan was the first major country to condone a negative yield environment, but its 10yr paper is now north of 0.7%.

 

 

 

These moves are going to put pressure on bond portfolios, both institutional and retail, however, the percentage correction this year still pales next to 2022. Furthermore, these are yields that are not sustainable, in my opinion. What do I mean by this? For one, financial conditions (as measured by the Bloomberg U.S. Financial Conditions Index) is back in negative territory for the first time since June and this is only exerting more drag on the economy. I listened to someone this week claim that only 11% of household debt is tied to adjustable rates. Unfortunately, this was wrong.  Last year, roughly 10% of U.S. mortgages were floating, but mortgages represented 70% of total household debt at the end of June ($17.06 trillion). In other words, the amount of overall debt affected by floating rates is closer to a third. Furthermore, not all fixed-rate mortgages in the U.S. are maturing 30 years from now. Every month, quarter and year a mortgage comes due and is going to get rolled into a more expensive one.

 

 

Second, as much as some investors may be getting stopped out on long positions in bonds, there is another segment of the market out there with cash looking at stop losses as creating an opportunity to add exposure. And this is why we have held cash through this period and look at slips in the bond market as exactly that opportunity. Back in the fourth quarter of last year we accelerated our purchases of bonds and there was a decent run-up until around March. The market has slipped since then, but consider this. The Canadian Bond Universe Index is down less than a percent from its low back in October of last and has a total return (based on interest earned and reinvested) of more than 2%. Contrast that to the 15% total return loss in 2022 to that October low. No comparison.

 

 

Warren Buffet is known for so many quotes, but there are two that are fitting today. First, it’s only when the tide goes out that you find out who was swimming naked. Well, we might just see some skinny dippers show up in the headlines after the latest jolt in yields. Second, and more appropriate here, is “be fearful when others are greedy, and be greedy only when others are fearful”.  Cracks formed by the elevation in bond yields, a possible shutdown and prolonged auto strike will take the tide out, but will create a little fear too.

 

 

On an even more positive note, we are pleased to announce that the monthly Pyle Group conference calls are resuming after the summer break and the first one will be next Wednesday October 4^th.  As usual, we will be sending out an email with the dial-in information.

 

On behalf of the Pyle Group, have a wonderful weekend.   

 

Andrew Pyle

 

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Andrew Pyle is an Investment Advisor with CIBC Wood Gundy in Peterborough. He and his clients may own securities mentioned in this column. The views of Andrew Pyle do not necessarily reflect those of CIBC World Markets Inc.