Wednesday, June 29, 2022

Raise interest rates or we’ll do it for you

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Jerome Powell played with fire, and the US economy is about to get burned. The bond market will be the incinerator.

The bond market doesn’t get the attention it deserves. People are myopically focused on the Dow, the S&P, the Nasdaq because average investors don’t indulge in bonds the way they do stocks.

But bond markets are uncanny in predicting economic troubles ahead. The Biden administration may have touted “transitional” inflation, but bonds early on sniffed out the BS.

Now bonds are sniffing out more BS in the Fed’s policy of incremental interest rate hikes in an effort to quell rising inflation. Bonds are saying it’s not enough; we’re going to need much higher rates and possibly a recession if we want to get inflation back to a more manageable level.

How did we get to a place were we need a recession? In recent years bonds have offered very little in return as the Federal Reserve kept buying them to pump up the economy though financial collapses, economic slowdowns and the pandemic.

That action, known as quantitative easing, infused the economy and markets with liquidity (a euphemism for “printing money”). It pushed up prices on stock and lowered interest rates dramatically, which initially made bonds unattractive because of the lower returns, or yields.

Federal Reserve Chairman Jerome Powell announced the Federal Reserve is raising interest rates by a half-percentage point to combat record high inflation.

For awhile the bond market was fine with that as long as inflation remained contained. But the economy and markets soared by too much. Borrowing became almost free with low interest rates and people used it to buy homes, stocks and everything else. New asset classes like crypto created money out of thin air.

It was all good until inflation set in – as it always does when government policy oversteps itself. The economy overheated to the point that inflation ate most of your paycheck. The official number announced last week is 8.6%, but the real number that isn’t massaged by the government is probably in the double digits.

Now no matter how much you might have made in crypto or on the value of your home, you find it difficult to buy food for your family or fill up your car. Inflation is a tax on the everyone but hits the working class hardest because they’re stuck in a miserable cycle to make ends meet.

The policy tools to end inflation are limited. Literally the only thing the central bank – aka the Fed – can do is create an economic slowdown by raising interest rates. And that is why markets are tanking.

But the Fed is not the only game in town controlling interest rates. Bond traders do as well, by trading so-called fix income investments that are highly sensitive to inflation.

When inflation spikes, bonds and the interest payments they deliver, as well as principal they pay at some date in the future, are worth less.

Thus their prices fall and their yields spike— investors demand more for their risk of inflation eating returns. That drives up interest rates on everything. The US economy contracts as consumers stop spending on homes (already we’re seeing mortgage rates increase) and other stuff; businesses borrow less to expand because it’s more expensive. Unemployment rises and you get a pretty deep recession.

You would rather have the Fed controlling interest rates than the bond market. The government can try to take it slow, whereas the bond market is agnostic to the suffering of the American people. But by buying so many bonds to keep the economy awash in case, Jerome Powell lost a lot 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 flashing warning signs – saying that it’s not enough.

They’re also saying if Powell doesn’t fix the problem, the bond market will do it for him. And the pain to the American people will only get worse.

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