Jerome Powell played with fire, and the American economy is about to burn. The bond market will be incinerated.
The bond market doesn’t get the attention it deserves. People are short-sighted focusing on Dow, S&P, Nasdaq because average investors are not involved in bonds the way they do stocks.
But bond markets are adamant in predicting economic troubles ahead. The Biden administration may have touted “transitional” inflation, but bonds quickly smelled BS.
Bonds are now sniffing more BS in the Fed’s policy of increasing incremental interest rates in an effort to suppress rising inflation. Bonds is saying this is not enough; If we want to bring inflation back to a more manageable level we will need much higher rates and possibly a recession.
How did we get to where we needed the slowdown? Bonds have offered little in return in recent years as the Federal Reserve continued to buy them to pump up the economy though financial collapse, economic recession and pandemic.
That action, known as quantitative easing, infused the economy and markets with liquidity (a euphemism for “printing currency”). This pushed up prices on stocks and lowered interest rates dramatically, which initially made bonds unattractive due to low returns or yields.
The bond market was okay with this for some time until inflation was contained. But the economy and the market grew enormously. Borrowing became almost free with low interest rates and people used it to buy houses, stocks and everything else. New asset classes like crypto made money out of thin air.
This was all good as long as inflation did not increase – as is always the case when government policy outweighs itself. The economy overheated to such an extent that inflation consumed most of your paycheck. The official number announced last week is 8.6%, but the actual number that hasn’t been massaged by the government is probably in the double digits.
Now no matter how much you earn in crypto or on the value of your house, you find it difficult to buy food for your family or fill your car. Inflation is a tax on all but affects the working class the most as they are caught in a miserable cycle to make ends meet.
Policy tools to address inflation are limited. Literally only the central bank – aka the Fed – can create an economic downturn by raising interest rates. And this is the reason why the market is falling.
But the Fed isn’t the only game in town controlling interest rates. Bond traders also do this by trading so-called fixed income investments that are highly sensitive to inflation.
When inflation rises, the bonds and interest payments they disburse, as well as the principal they pay off at some future date, become worth less.
Thus their prices fall and their yields increase – investors demand more to eat the returns for their exposure to inflation. It raises interest rates on everything. The US economy contracts as consumers stop spending on homes (already we are seeing a rise in mortgage rates) and other goods; Businesses tend to borrow less for expansion because it is more expensive. Unemployment rises and you get a very deep recession.
You would prefer the Fed to control interest rates than the bond market. The government may try to take it slow, while the bond market is oblivious to the suffering of the American people. But by buying so many bonds to keep the economy moving, Jerome Powell lost much of the leverage to engineer what’s known as a “soft landing.”
Powell is set to raise short-term interest rates this week, but the bond market is showing warning signs – saying it’s not enough.
They are also saying that if Powell doesn’t solve the problem, the bond market will do it for them. And the pain will only get worse for the American people.