Mr. Market Is Doing His Thing
Do you remember the last time the bond market threw a tantrum?
The year was 2013, and the country was several years removed from the financial crisis's depths. In response, the Federal Reserve embarked upon the most significant expansion of its balance sheet in history via what was known as "Quantitative Easing."
This quantitative easing involved the central bank becoming the predominant buyer of Treasury and other fixed-income securities, all of which forced prices higher and yields lower. The idea was that lower yields would stimulate the economy sufficiently to repair the damage from the housing market collapse.
The policy worked. Interest rates dropped precipitously, and asset prices, including equity securities, moved higher. The only problem was that economic growth did not trigger inflation.
While inflation is generally considered a big no-no, some inflation indicates a healthy economy. As such, the Federal Reserve's stated target for inflation is 2%, not 0%, according to central bank statements on the topic.
According to the Bureau of Labor, inflation in 2011 and 2012 (as measured by the consumer price index) ran above that rate at 3.16% and 2.07%, respectively. This should have put upward pressure on interest rates. However, unemployment remained stubbornly high. During those years, the unemployment rate was 8.9% and 8.2%, respectively, which kept interest rates low.
That would all change in early 2013 when then-Fed Chairman Ben Bernanke stated that at "some point in the future," Quantitative Easing would end; the central bank would pull back from its buying of fixed-income securities.
That was all it took to move interest rates higher.
The fact that interest rates immediately rose told us that the true market interest rate was higher. That without the Fed, the equilibrium interest rate reflecting market supply and demand was higher than where rates had been.
At the time, market pundits speculated that the Fed was backing away from its bond-buying too soon. They worried that neither the real estate market nor the economy was on firm enough footing to tolerate higher interest rates. Most were enjoying the effects of low-interest rates and didn’t want to see them rise. They hoped the Fed would change its mind and continue being a big buyer in the market.
The Fed did not back away from its bond-buying program in 2013; they stuck with the policy. We've worked our way back to true price transparency ever since. Well, sort of.
The Federal Reserve continues to be a massive player in all investment markets with its power over the level of interest rates. They did try in 2018 to move rates back to more "normal" levels but met with a sharp pullback in stock prices and criticism from many quarters. Once again, the Fed reversed course.
With the arrival of the pandemic, the Fed was forced to take even further action. Massive selling in March of 2020 caused the central bank to step in and become the buyer of last resort in the markets. Initially, the policy was aimed at market stabilization but soon became an effort to help the economy out of recession.
Today, the Fed is holding to its low-interest-rate policy, indicating it will make no changes until 2023 at the earliest, according to central bank testimony to Congress in late February.
Why then is the bond market moving? Why are we seeing interest rates rising? According to Yahoo Finance, this year, we have witnessed long-dated rates jump more than 50 basis points.
I think for the first time in a long time, the bond market is showing us something we may have forgotten… the Fed has a lot of influence over interest rates but cannot exercise control in all circumstances. We may be seeing that interest rate levels could be moving out of the Fed's immediate control.
The current move up in rates is the result of a confluence of factors. The market assumes that as the pandemic subsides, economic activity will accelerate. In fact, the market thinks we could have an economic boom once everything opens.
For almost a year now, consumers have, by and at large, been locked down. Americans are not known for being good savers. Our propensity to spend is one of our economic growth bedrocks; Americans like to spend their money. However, we've seen the savings rate move higher during this past year, to levels seldom seen. For the past year, American's have been saving.
The market today assumes Americans will revert to their spending ways as soon as they are able and, as a result, we will see economic activity soar.
But the increase in interest rates also has a dark side. Many worry about the impact of another $1.9 trillion in economic stimulus now being considered by Congress. They worry that this amount is unnecessary, poorly timed, and highly inflationary. And it's not just expectations. We are beginning to see tangible evidence of higher prices that may drive inflation above the targeted 2%.
One argument along these lines harkens to the concern about fiat money. That is, the government does not have the money it's spending; they have to borrow to spend it. Ultimately, this is thought to lead to the government simply printing money to pay its bills, causing a collapse in the dollar's value. In this set of circumstances, diminished purchasing power causes inflation.
But we don't see the current situation as following that line of thinking. Our concern is that Americans spending this government stimulus as the economy opens will push up prices because the demand for goods will outstrip supply. We worry the government is spending when they don't have to.
If inflation rises due to these factors, I think there will be little the Fed can do to stop inflation and its effect on interest rates. Actually, the Fed would be in a bit of a box. They would need to tighten the money supply and raise rates to slow the growth pace, which is a complete policy reversal that most view as highly unlikely. This is why we could go into a protracted period of higher-than-normal inflation.
So long as investors see this as a risk, they will demand higher interest rates on the money they are lending to the bond market.
If you are concerned about rising interest rates and would like to learn more about how we can help you navigate the current environment, please give me a call to discuss.