A Reuters article by Stefano Rebaudo argued that the Federal Reserve might welcome a “bond market tantrum” that pushes bond yields higher. But does the Fed really want higher interest rates? And what would that mean for the economy?
Despite the post-pandemic economic improvement and wide expectations that the Fed will begin tapering quantitative easing in the near future, bond yields have remained stubbornly low. Ten-year Treasury yields remain stuck just above 1.3%.
Analysts cited in the Reuters report said the Fed “needs bonds to respond to the end of the pandemic-linked recession.”
ING Bank research analyst Padhraic Garvey told Reuters higher yields would align markets more with the signals coming from central banks.
“To facilitate that, we argue that there needs to be a tantrum. If the Fed has a taper announcement … and there is no tantrum at all, that in fact is a problem for the Fed,” he said.
Analysts say a bond market tantrum would involve yields rising 75-100 basis points (bps) within a couple of months.
What Would It Mean in Practice?
This isn’t just a wonky discussion about interest rates. What we’re really talking about here is a big sell-off in the bond market.
Bond yields move inversely with bond prices. As the price of bonds drops, interest rates rise. Bond prices and yields move in response to supply and demand. Higher supply and lower demand will push the price down and yields up to stimulate buying. Conversely, a lower supply of bonds, or higher demand, will drive the price up and yields will fall.
So, when analysts talk about a bond market tantrum, they mean a bond sell-off that will flood the market with excess Treasuries, drive the price down and push interest rates up.
According to the Reuters article, the Fed not only wants higher yields to “better reflect” economic growth; it also wants to “recoup some ammunition to counter future economic reversals.”
But this analysis completely ignores the elephant in the room – debt – specifically the federal debt.
Why Are Yields So Low to Begin With?
This is a key question the Reuters article never takes on. But it’s the key to understand what is actually going on in the bond market.
The answer is simple. Yields are low because the Fed continues to create artificial demand in the Treasury market by purchasing some $80 billion in bonds every month. It launched this massive QE program at the onset of the pandemic and it continues today unabated. The Fed literally has its big fat thumb on the bond market.
Because the US government needs the central bank to buy Treasuries to support the bond market in order to finance its multi-trillion budget deficit. Without Fed intervention, the flood of borrowing would tank the bond market and send interest rates soaring.
In a nutshell, the central bank facilitates the federal government’s excessive borrowing and spending by creating artificial demand in the bond market. The Federal Reserve buys Treasuries on the open market with money created out of thin air. This supports bond prices and keeps interest rates artificially low. Without this central bank intervention, there wouldn’t be enough demand in foreign and domestic markets to absorb all of the bonds the US Treasury needs to sell. Interest rates would skyrocket and make the cost of borrowing prohibitive.
Between March 2020 and May 2021, the federal government has added $4.7 trillion to the national debt. In roughly that same time period, the Federal Reserve purchased a staggering $2.44 trillion in US government bonds. In other words, the Fed monetized more than half of the US debt accrued during the first year of the pandemic. No other entity bought more US bonds than the Fed – not foreign investors, not US banks, and not even US corporations and individuals.
The Question Reuters Never Asks
Debt monetization never comes up in Reuters' analysis. But this is a significant question: how would a bond market tantrum impact US government borrowing and spending? And will the Fed really let this happen?
A bond market selloff would make it more difficult for the US Treasury to sell bonds. Remember, the Fed’s thumb on the market helps make the borrowing spree possible.
And the borrowing and spending are not about to end any time soon. Congress is working to pass a massive infrastructure bill. Along with Biden’s proposed budget, we’re looking at some $6 trillion in spending in 2022. To put that into perspective, total federal spending for fiscal 2021 stands at $6.3 trillion with one month remaining. In other words, the Federal government wants to spend almost as much next year as it did this year.
This means the US Treasury will have to continue selling bonds at a torrid rate. How will it do this if the Fed pulls the plug on QE? How will it continue to borrow if interest rates spike? A bond market tantrum is a nightmare scenario for the US government. This is precisely why Peter Schiff says even if the Fed starts to taper, it will ultimately expand QE.
Last summer, Federal Reserve Chair Jerome Powell claimed the central bank isn’t monetizing the debt. During testimony before the Senate Committee on Banking, Housing, and Urban Affairs back in June, Powell flatly denied the central bank is buying assets in order to facilitate the Treasury’s sale of debt. “That certainly is not our intention,” Powell said.
It wasn’t in any way about meeting Treasury supply, and it continues not to be. We really don’t think about it.”
Powell then claimed that the demand for Treasuries was “robust.”
But as already discussed, the demand for Treasuries was only robust because the Fed was buying Treasuries.
As far as Powell’s claim that the Fed doesn’t “think about” the ramifications of its monetary policy on government financing, I call BS.
The glib assessment of a “bond market tantrum” by Reuters only shows part of the picture. Sure, in some ways, the Fed bankers would like to see bond yields increase. They would like to taper asset purchases. But they haven’t and there’s a reason for it. They have to know the ramification of rising interest rates in a world buried by debt. They have to know the US government needs the central bank’s thumb on the bond market.
The Fed is between a rock and a hard place. Reuters identifies the rock but ignores the hard place.