Bond markets are sending us a warning about our profligate politicians

Mistaking spending borrowed money for growth is one of the curses of our age. It has been fostered by the obsession with GDP as the measure of all things.

via Alamy/ 3A64WAP

"Something which we think is very important in western economies", wrote my commodity guru in his Friday wrap, is that "politicians think politics trumps economics, while business sees it vice versa and economics dominating politics. This causes them to be like two ships often passing in the night”. I myself am presently mesmerised by the politics.

He and I have long agreed that the West has got itself into a fiscal death spiral which has him as a great fan of the Trumpian DOGE project. Where we disagree is that he does not see Elon Musk’s resignation as the slasher-in-chief of government waste as a sign of failure but looks at what he has achieved and believes that from small acorns do great oak trees grow. I am less sanguine and feel tempted to suggest that 140 days after the inauguration, it is fair to declare the Trump presidency as being in the process of failing. What lies in store for the 1,323 days until the 2029 inauguration is anybody’s guess.

Regular readers will know that I have never much cared for Elon Musk, and not only because I am a proper petrolhead who has since early days - and on scientific as well as emotional grounds - been sceptical of the cult of the EV. The love-in between Trump and Musk along with all the “first buddy” nonsense had me spitting tacks and I was one of many who wondered just how long this would last. The image of Musk standing in the Oval Office behind the President in suit and t-shirt and wearing a red MAGA cap looked and felt wrong. The man who had made the larger part of his fortune from electric cars and the king of “drill, baby, drill” – that didn’t even wash as a marriage of convenience.

The spat between the world’s richest man and the putatively most powerful one has been laid out and has had lights shone on it from all angles with millions of words written but still the most fundamental issue has not been properly discussed.

Musk is quite right to question much of the President’s One Big Beautiful Bill and to highlight what he calls the pork. Pork barrel politics is not idiosyncratic to America but it is there that the spade was called a spade and where the phrase was coined. It is in essence the targeted spending of public money to the electoral benefit of individual politicians but goes further in that the administration will “buy” congressional votes by promising to financially support local needs. It’s political “I’ll scratch your back if you scratch mine”.

Coming from Musk, this is big talk as has been demonstrated by the President’s hitting back and threatening to cancel billions of dollars’ worth of federal contracts with Musk’s various business entities, especially with SpaceX. Is Trump not quite openly telling us that, if these contracts can be cancelled on personal grounds, that that must have been how they were awarded and that they reveal for all intents and purposes a hard-to-dispute and egregious case of corrupt practice?

I have for long argued two basic cases. The first is that the measure of debt to GDP and deficit to GDP are a waste of time. The government cannot spend GDP. It can only spend tax take and therefore it is the relationship between it as an income stream and whatever appears on the expenditure side that counts. Currently the US government annually spends around US$ 7 trillion but only receives US$ 5 trillion. Thus, for every dollar it spends it has to borrow around 30 cents. When sweeping into his role at DOGE, Musk declared he could save the government over US$ 2 trillion which would have in effect eradicated the deficit. I think the latest count is at US$ 180 billion. That’s not chicken feed but it does not do enough to permit the White House to go out on the spending spree that is enshrined in the Big Beautiful Bill. Trump is preaching fiscal discipline whilst intending to practice egregious profligacy. No wonder Musk has thrown his toys out of the pram.

Mistaking spending borrowed money for growth is one of the curses of our age and one which has been fostered by the obsession with GDP as the measure of all things. The United States is running a self-confessed federal deficit of 6% of GDP which equates to give or take 40% of tax take and yet the myth persists that cutting taxes will generate the growth that will somewhere in the future lead to a surge in the economy and hence to a balanced budget. Donald Trump is not wrong when he cries out for DOGE, with or without Elon Musk, to rein in institutionalised waste but what is wrong with reining it in for its own sake? And why does he persist with his dream of spending the savings before they have been made?

Over here in the UK, the situation is the same but different where Chancellor of the Exchequer Rachel Reeves, that famous ex-Bank of England economist, has been busily spending higher income resulting from increased taxation before it has arrived in HM Treasury’s bank account. So, it doesn’t really matter whether fiscal revenue is missing target because taxes have either been raised or cut, the resulting mess is the same.

Over the weekend, the Financial Times carried as its “Big Read” an article titled “The mounting pressure on bond markets” which was subtitled “For the first time in almost a generation, governments are starting to face regular resistance from investors when they try to sell long-term debt”. In it, there is a Who’s Who of global finance from Larry Fink to Ken Griffin to Jamie Dimon to Ed Yardeni and all stations in between opining on the unsustainability of current budget deficits which of course once a year when the governments’ P&Ls are reset to zero are added to their respective national debt piles and which markets are invited to finance.

Wherever I go, I seem to find myself introduced as the guy who writes a column about bonds. Nearly but not quite. In fact, bonds write my column for me for bond markets have an uncanny habit of revealing the truth about government, the economy and their relationship to one another. Quantitative easing intervened and tried to manipulate that relationship by forcing long term rates lower by way of the central banks buying long term debt. They created a false market, and I recall writing at the time that if any one of us had tried to perform even a minor percentage of that form of market manipulation we would today still be lingering in prison at His Majesty’s pleasure. It was President Abraham Lincoln who coined the phrase that you can fool all of the people for some of the time and some of the people for all of the time but you cannot fool all of the people for all of the time and it is in that vein that the unwinding of QE, commonly referred to as QT, quantitative tightening, is laying bare the lie created by QE that over a longer period of time the yield curve can be manipulated with impunity. The much vaunted bond vigilantes – a sobriquet created by Ed Yardeni in the 1980s – are not the ones writing the book but simply the ones reading it aloud to those who have forgotten where in the library it has been stored.

Think of QE as the life support system that kept the economy ticking along in the aftermath of the GFC and again through the Covid crisis. With the life support system doing its bit the patient was breathing easily. Is he doing so because of or despite life support and if removed will he continue to breathe or will he simply turn up his toes? Bond vigilantes – how I hate that phrase - are not as the name might suggest sitting out there waiting to ambush and rob government debt agencies. All they are doing is looking to establish the correct return for the risk embedded in any bond by any borrower for any given maturity. It’s not a quiz. For too long borrowers, both public sector and private, have been permitted and even encouraged to borrow too much too cheaply and the chickens are coming home to roost. The last 20 years have been dominated by the belief that central banks can lead rather than respond to the economy, that cheap money can and will of itself foster inflation free growth. President Trump’s constant and petulant badgering of the Fed to cut rates is the perfect expression of that naivety. The truth is written in rising long term rates and in the growing fear of them going ever higher. The US 2 year/10 year yield differential is still only 49 basis points – 4.01% vs 4.50% - and my guess is that even if the Fed were to cut by 1% as Trump wants them to do and which they won’t, the cost of 10 year money would still rise rather than fall.

QT, quantitative tightening, has seen the Federal Reserve’s balance sheet fall from US$ 8.965 trillion in April 2022 to US$ 6.672 trillion as at last week although that fall of US$ 2.3 trillion still only represents half of the increase generated from the US$ 4.158 trillion it had reported in February 2020. We could now start playing the percentage game of which I shall desist but suffice to say that the Fed still holds on its books the equivalent of three years of government deficit and every cent by which it reduces its holdings has to be refinanced by markets for whom buying bonds is not a charitable act. Markets are not to be blamed for rising rates, profligate governments are and I was a rare beast, albeit not entirely alone, when I queried the belief that quantitative easing represented a solution to rather than a postponement of many of the issues of excessive and mispriced debt that had blown up during the GFC.

Chancellor Reeves is now running around insisting that UK pension funds should be obliged to direct funds towards the private markets. I’m not quite sure what planet she lives on, but has she not clocked that private equity does not raise capital for industry. It looks for underpriced assets, leverages them up and tries to flog them off at a profit, ideally by way of an IPO. Private equity is all about the exit strategy and if she were to switch on either of her brain cells she would note that the entire sector is creaking under the strain of there being a critical dearth of exits and of an industry sinking in its own sea of debt. As far back as November 2023 John Plender, one of the grand old men of the FT, warned in the Long View column of the critical interplay of the high cost of money and the difficulty of bringing companies that had been taken out of the public market back into it.

On their face stock markets are looking buoyant and in the media there is much excitement that some indices are heading for new all-time highs – at north of 6,000 pts the S&P 500 is only 2.5 % below its record high - and yet the initial public offering end is struggling and from a private equity perspective pretty much as dead as a dodo. That is where our dear Chancellor wants our pension funds to find themselves obliged by law to put our retirement savings. The world is not a perfect place, and markets are not perfect either. But they do have a habit of finding the falsehoods and exposing them. The bigger the lie, the bigger the bang when it is exposed to the cold light of day. Countless trillions of dollars and pounds and euros of corporate assets are sitting on the books of private equity firms, every single cent and penny of which is ultimately supposed to be profitably returned to the public market. That’s the theory. The continual growth of assets in the hands of private equity would seem from where I am looking to demonstrate that somehow the model isn’t working. Or am I missing something?

So, off we trot into a new week. Donald Trump was going to end the war in Ukraine in the first week of his presidency. Nope. Gaza? Nope. Iran? Nope. DOGE? My commodity guru insists that DOGE must be given time. I agree but that is not what the American people were promised. His fall-back on 50% tariffs on steel and aluminium looks like a desperate grab for a win in a tariff war that has not gone to plan. And now the One Big Beautiful Bill has to face the Senate. The pushback against the administration’s belief in its infallibility is taking shape in many areas, of which the demonstrations in California are merely the latest manifestation. The vicious end to the Trump/Musk bromance? Has Trump reshaped America and global trade? Yes, but most likely not quite in the way he, his acolytes and his voters had intended and it’s all still a work in progress. Meanwhile I did watch the Roland Garros final. What at the beginning looked as though it was going to be a Sinner parade turned out to be anything but. It truly was a tennis match for the ages.