A Reader Asks: What is Mr./Ms. Bond Market trying to tell us?

A reader asks: what is Mr./Ms. (Bond) Market trying to tell us?

Archer replies: Many years ago an old friend went to see Max Faget in Texas. Faget was an engineer and the chief designer of the Mercury spacecraft that launched the first American into space in the 1960s. In the course of their conversation Faget said to him, “There are many names (of the designers) on the Mercury capsule. Mine is first.”

Likewise, there are many people who have contributed to the current fiscal mess. In this case, however, it’s a little harder to determine who has pride of place; it’s been a bipartisan effort. You could, if you wanted, trace the modern infatuation with debt back to the Reagan Administration in the 1980s and the rise of supply side economics, championed by the unironically named Arther Laffer.

Laffer, who is still with us, is perhaps best known for popularizing the “Laffer Curve.” The idea is that at some level of taxation, reducing tax rates will result in increased tax revenue, a notion goes back at least to the 18^th century. There is evidence that confiscatory levels of taxation are indeed counterproductive. As then-treasury secretary Andrew Mellon (the country’s third highest taxpayer, per Wikipedia) said in 1924, “73% of nothing is still nothing,” referring to the tax avoidance provoked by the top income tax rate at the time.

But zero percent of zero is also zero. The challenge for Laffer Curve enthusiasts is to find a happy medium, where sufficient revenue is raised to pay for necessary government services without crushing the economy or causing capital to flee. It’s fair to say that this inflection point was not discovered by President Reagan or his advisors, and it has remained elusive. The federal deficit soared during the Reagan years and has generally continued to grow ever since, taking a brief period off during the Clinton administration in the late 1990s.

Two generations removed, we’ve become inured to the red ink. Various Cassandras predicting disaster have all been proved wrong or at least, as Wall Street likes to say, “early.”

Many investors give only a passing nod to the fixed income side of their portfolios. After all, lending money and getting it back with some interest is not all that exciting. Lending money and not getting it back, or getting it back in some bowdlerized fashion (i.e. inflation adjusted), is a little more interesting, but not in a good way.

This latter prospect has brought the Cassandras out in force again. Jamie Dimon, CEO of JP Morgan Chase and house prophet of Davos Man, has recently predicted a “crack” in the bond market though he’s a little unclear as to the timing (“six months or six years”). More significant is the reaction of Mr./Ms. Market, where those who vote with their money tend to have the last word. There the rumblings of discontent have been getting louder.

Treasury Secretary Bessent has said that the U.S. will never default. Maybe not, but nobody says the world has to buy 30-year treasuries at 5% forever.

Somewhere back in the early junk bond era (1989-1990 or so) “leverage” replaced the more pejorative “debt” as the term of art for those who would be borrowers. The idea of hamstringing the balance sheet with excessive liabilities – bad. But call such a thing leverage and suddenly every CFO under the sun is Archimedes, moving the world.

But semantics wasn’t sufficient to keep junk bonds afloat 35 years ago and if it comes to it, it won’t work with treasuries either. When credit quality declined and defaults rose, prices tanked, and the buyside disappeared. The leading junk bond underwriter, Drexel Burnham, went bankrupt. It was bad.

The first crewed mission of a Mercury capsule traced a parabola across the sky in a suborbital flight – gravity’s rainbow, as Thomas Pynchon characterized it – splashing down in the Atlantic.

The U.S.’s credit rating is on course to follow a similar path, even as the nation’s debt is close to achieving escape velocity. One reliably wrong prediction has always been “it’s different this time” and that may again prove the case. But when the bond market tries to tell you something, it’s at least worth listening.

Woof!