The Bond Market Is Calling the Fed’s Bluff – Things Aren’t Looking Good

Via Adem Tumerkan  @ Palisade-Research.com

 

Yesterday the Federal Reserve’s FOMC Minutes confirmed what we’ve been thinking – that the Fed will find a way to justify higher-inflation without raising rates faster.

But what really made me laugh were comments made by James Bullard – President of the St. Louis Fed Bank.

He said that the yield curve has a “nice slope” and there is currently no danger of an inverted yield curve.

But – ironically – the yield curve got even closer to inverting after his words and the FOMC’s comments about expecting a rate hike in June. This news was supposed to make the spread widen.

Looking at the 2 n’ 10 Rule – the spread between the 2-year and 10-year rates – we still see the spread at its tightest since the 2008 recession.

Remember, the last 9 out of 10 recessions were preceded by an inverted yield curve.

And today there is only a 0.46 spread between the two rates – and it’s closing in on negative.

So, what yield curve ‘slope’ is Mr. Bullard talking about? 

Besides his comments, what’s worrying me is that the annual inflation is well above the Fed’s ‘2% target’. And – even worse – the FOMC believes now this could be “helpful”.

Since when is paying more for goods and services helpful?

The only thing helpful from all this was two revelations from today’s Fed Minutes.

First Revelation. . .

 

We now know that the Fed will run the economy hot with inflation instead of hiking faster. The Fed could’ve justified hiking during the last meeting because of how much inflation is rising.

But they know that the very fragile U.S. economy can’t handle rising short-term yields. . .

Rising yields makes it harder for debtors to service their debt. And with American consumers indebted up to their necks – and the U.S. government’s growing deficits requiring more financing – this would be very damaging.

One big example, banks depend on borrowing ‘short’ and lending ‘long’.

What this means is that banks and hedge funds borrow short term debt and invest the funds in the long term high-yielding market.

For instance, a local bank will borrow from the Fed at 1.75% then turn around and lend it out to a mortgager at fixed rate of 4.5%. Their ‘nominal’ profit (before subtracting inflation costs) being the difference – which is 2.75%.

Many economic crises have happened because of short term rates shooting higher then long-term ones. It creates illiquidity problems. And many bank runs have started from this.

So now that we know the Fed will put up with much higher inflation than their ‘2%’ target rate – like we expected – but how much higher is yet to be seen.

Second Revelation. . .

If the Fed is hiking rates, unwinding their balance sheet through Quantitative Tightening – selling their bonds – and with inflation already at 2.5% and rising, why are investors buying 10-year bonds only yielding 2.99%?

Inflation alone is killing the ‘real’ gains – for instance, a 2.99% yield minus 2.5% inflation equals only 0.49% ‘real’ profit.

That’s more than an 85% ‘real’ loss. . .

And since the Fed said they’re okay with even higher inflation – that means the 10-year bonds bought today are facing serious ‘real’ losses.

So, the real question is – “why are investors today buying long dated bonds when the Fed is hiking rates, running Q.T., and inflation is rising?

Shouldn’t investors be selling their bonds and asking for higher yields to protect themselves from the coming inflation and rate hikes?

The only answer I can think of is that the bond market is calling the Fed’s ‘economic growth’ bluff.

They understand that the U.S. economy is fragile. And that the chance of deflation and recession is very likely within the next few years.

If bond holders expect an economic slowdown and deflation ahead, then they know the Fed will quickly reverse their tightening, begin cutting rates, and start buying bonds through another round of Quantitative Easing.

And when bond yields go down – that means bond prices go up.  

If this scenario plays out, that makes the currently ‘not-so-profitable’ bonds suddenly very profitable. . .

Bond investors are the ‘smart’ investors – so if they’re calling the Fed’s bluff, it’s very concerning.

 

These two revelations give us an idea of what’s really going on.

The economy is too weak for more hikes, and the bond market isn’t buying into the mainstream medias growth story.

The 2 n’ 10 Rule shows that the yield curve is dangerously close to flattening – then soon afterwards inverting. And not even rate hikes, Quantitative Tightening, or rising inflation is enough to shake this trend.

Sorry, Mr. Bullard, but we’re calling your bluff. . .

Comments

Catullus Thu, 05/24/2018 - 22:32 Permalink

Or there's a shit of negative yielding bagholders in Europe and Japan who are looking at 3% in the global reserve currency and thinking "I can take my negative yield in euros or yen and park it in US 10 years at 3%. And I don't have to worry about FX risk, because my central bank is printing money like it's 2009, and the US is tightening. Win-win. 

Hell, why bother with the bonds? Why not just lever up, buyout a cash flow rich US company, sell my newly issued LBO bonds to the ECB or Japanese CB, and a play corporate tax entity shell game."

pitz Catullus Fri, 05/25/2018 - 00:38 Permalink

A negative yield in Euros or Yen may very well be a higher return than a positive yield in likely to heavily depreciate dollars.  

There's a reason why banana republic currencies also have high rates of interest.  Its not because they're good investments, that's for sure.

In reply to by Catullus

pitz Fri, 05/25/2018 - 00:37 Permalink

Banks do not 'borrow' from the Fed.  They borrow from various sources, but the use of the Fed's "discount window" is basically of last resort, requires collateral, and is fairly expensive relative to other potential sources of financing.  

 

U. Sinclair Fri, 05/25/2018 - 01:18 Permalink

It's a circus act.
The FED (and all other Central Banks) are walking on a rope and the rope gets smaller and smaller.
This time, however, they removed the safety net...

chestergimli U. Sinclair Fri, 05/25/2018 - 08:01 Permalink

Prices on everything have gone up since 1913 and the (((tribe))) got the income tax to pay for spending by the US government.  All governments, for that matter with a central bank, have done the same.  Spend and spend and tax and tax because the citizens are too dumb to know what is going on.  Those who can understand what is going on will remain silent about it as they can see the advantages to it.  A quote by a promoter of both federal reserve and graduated income tax.

In reply to by U. Sinclair

CHX13 Fri, 05/25/2018 - 02:19 Permalink

It's all smoke and mirrors with bogus numbers anyway. Inflation measured the original way (hat tip to shadow stats) has been much higher than 2% for many many years. They just spew whatever BS they like to twist and turn the "markets" whichever way they want. Nothing new under the sun.

TheRideNeverEnds Fri, 05/25/2018 - 03:30 Permalink

Oh look, another arcane metric you can point to for why you are missing out on the next leg higher.  

You think Amazon, Facebook and Netflix stock gives a shit about the yield curve?  Hell no; just buy it! 

Truth Eater TheRideNeverEnds Fri, 05/25/2018 - 07:44 Permalink

Actually, yes.  Who buys the FANG stocks?  Not you.  Not me.  But hedge funds and banks.  Big money managers.  And when they see these stocks topped out as yields on bonds are higher, they may just park a good portion of their money in bonds and wait to see if the big stocks drop from their ridiculous non-performing prices.  What is the ROI on any of those stocks?  Only what a greater fool will bid them up speculating.

In reply to by TheRideNeverEnds

looks so real Fri, 05/25/2018 - 08:07 Permalink

Inverted yields was yesteryear's truth today technology is so good it can fix any problem that comes up with fast transfer of digital money. This is why it's only a flash crash in a few weeks it's up and running again.

platyops Sat, 05/26/2018 - 02:25 Permalink

It is all a Ponzi as we know. But when gold fires up and up is the question.

Hard to figure out with all the PAPER gold hanging about.

But I bet you won't see the government of China buying PAPER GOLD. No not at all they will only buy the real deal. If you try to sell them Tungsten painted gold they will blow the whistle on you.

PAPER GOLD's days are numbered, Vaults holding your gold and giving you a chit for it are numbered, Gold and Silver leasing days are numbered!

Keep Stacking The Real Deal!