Jerome Powell, Federal Reserve chairman speaking in Washington DC at the Economic Club of Washington on Jan 10th indicated the Fed would adjust the Federal Funds rate higher as needed at a pace reflective of conditions. This signaled they may slow the pace of adjusting the Federal Funds rate back to a more normal level commensurate with the level of economic output and expected inflation.
On its own, this should have no impact on interest rates or other financial markets as it has been widely telegraphed. The most likely path in the short to medium term for the Fed rate adjustments did not change.
However, he continued to say regardless of the exact timing of the Federal Funds increases, the balance sheet will continue to be reduced on its current trajectory. This had a steepening impact on the level of rates – acknowledging risk taking and the ability to hold long term bonds on the balance sheet and manipulate long term rates may be nearing its end. The flat yield curve, void of interest income that compensates for interest rate risk embedded in long term bonds and with heavy issuance and no central bank support (rather central bank pressure), seems to now have significant pressure to limit further flattening and in fact reverse this trend.
The long term flattening trend in the bond market was the work of the Federal Reserve’s manipulation of interest rates. The Fed’s balance sheet was increased to around 5 trillion from 500 billion during their quantitative easing campaign as a result of the financial crisis of 2008. This lofty amount of liquidity released into an economic system is associated with creating elevated levels of inflation. And that is exactly what was experienced. Though inflation in some goods and services were impacted, aggregate inflation levels of goods and services were only modestly impacted. However, financial inflation was rampant. Equity markets produced over 100% returns. Bond markets experienced similar returns with long term bond yields reaching lows never before seen in the US and globally. And real estate and other tangible financial assets experienced rapid inflation as well.
At the beginning of the financial crisis, most financial assets were at low, inexpensive levels and some asset appreciation was warranted and necessary. However, the Fed kept their foot on the accelerator longer than required driving most financial markets to astronomically rich levels seldom if ever experienced. Replacing burst financial bubbles by reflating and creating additional financial bubbles and lofty conditions is a dangerous monetary policy to pursue – but it is a politically acceptable one as the ramifications of poor monetary policy is usually felt on another politician and Fed officials watch.
One of the results of this extremely short sited monetary policy is the overvalued levels currently in the bond market. With interest rates at zero and the Fed purchasing a large part of the available stock of longer term bonds in the market place, the Fed created a more mispriced bond market than the one that caused the financial crisis in 2008 in the first place. The Fed’s bond purchases encouraged a flood of capital to follow their footsteps and overinvest in the fixed income markets. This has led to trillions overinvested in a market place that is significantly mispriced from historically normal levels. Adding to the mispricing in the bond market, the Fed also acted like the world’s largest hedge fund and put on yield curve flattening trades, selling short term bonds and purchasing long term bonds outright.
Longer term bonds usually trade 2% to 3% above the rate of inflation. After such manipulation in the bond market, to reach this equilibrium, long term bonds would suffer 50% mark to market losses as rates rise 3% or more. That is a significant mispricing in what is perceived to be a liquid and safe market. Currently, cash and other short term bond yields are very close to those yields of the much riskier long term bonds. Why would anyone set themselves up for the embedded losses in long term bonds when short term yields are so comparable.
The most prevalent theory to accept such risk for limited returns is that there are signals in the shape of the yield curve – or how long term bond yields compare to short term bond yields. When long term yields approach short term yields, the prevailing theory is that a recession is near and the Federal Reserve will soon lower rates.
This is a good theory – but only works when you start from a market place that is not manipulated. With the Fed purchasing trillions and countless trillions running to the same market for a perceived sense of safety over the last 10+ years, this over invested market no longer offers any signals on short, medium or long term economic prospects.
To prove this, today the bond market steeped with long term yields rising. This was driven not based off of a lower probability of a recession nor positive economic news. No. This was driven by the Fed Chair Powell stating he would continue to let this enormous bond balance sheet roll off and be reduced to a more normal level.
Yes, pure risk taking and aggressive trading tactics are responsible for the flatness of the yield curve as traders and investors stuck with what was working, following the Fed and invested in overvalued bonds hoping they would continue to be overpriced. Now that a lever of support has been removed and balance sheet reduction is continuing, pressures are lining up signaling normalization in long term yields will continue. Add to this the unprecedented supply from rising debt levels and trade conflicts and the predictable good performance in the bond market looks to quickly turning into the 2019 loss leader.
Bond investors should expect to have poor performance in such an environment with limited yield to offset this inevitable repricing to more normalized levels.
But this mispricing of the yield curve due to excess risk-taking driven by Fed policy has other much more detrimental impacts to the economy. One large risk was what was experienced in 2008. When such mispricings in the bond market unwind, they can turn into systemic issues putting the financial health of the country in jeopardy. Yes, excessive volatility from the unwind of mispriced financial markets can impact otherwise healthy economic markets leading to severe recessions or depressions. Thus replacing one financial bubble with another, though may feel good in-between, is not a virtuous long term monetary policy to pursue.
So expect limited to no information from the shape of the yield curve in this cycle. In fact, be on the lookout for just the opposite expected economic indications from the yield curve. It is possible that the next recession corresponds with a steepening of the yield curve from these levels as a wave of debt from additional government spending is projected. The yield curve may be more of a reliable barometer of upcoming fixed income supply than anything else in this environment.
by Michael Carino, Greenwich Endeavors, 01/16/2019
Michael Carino is the CEO of Greenwich Endeavors, a financial specialist and a hedge fund portfolio manager, trader and owner of more than 25 years. He typically has positions that benefit from a normalized bond market, higher yields and value investments.