Everywhere you look, the financial media is in a full-blown panic. “The bond market is falling apart!”
At least that’s what they would have you believe.
But is it really falling apart? Or is it repricing to a normal level after years of suppression at much lower rates?
I covered this topic last week on the quarterly Zoom call with Strategic Trader subscribers.
More specifically, I talked a bit about the Federal Reserve’s recent decision to hike the overnight lending rate by 25 basis points. A decision I’ve openly criticized as unnecessary.
Some say the Fed did it in response to inflation. Others say it was a way to bring down yields in long-term U.S. Treasuries.
Maybe it was one of those reasons. Maybe it was neither.
Now, it’s a matter of looking at the data – both present and from history – that can help us chart a path forward.
The Fed
As I mentioned on the call, the Fed’s language on its decision to raise rates is telling.
In its official statement, the Fed said that the economy is expanding at a solid pace. That’s true.
For example, the Atlanta branch of the Federal Reserve keeps a real-time estimate of U.S. inflation-adjusted GDP growth. They call it GDPNow. It updates the figure often as new economic data comes in.
It’s not an official forecast, but it gives us a snapshot of the overall economy and what we may expect for the current quarter.
The most recent update to the GDPNow figure for Q3 was back on September 17. And it came in at 5.1% growth for the quarter. A massive number for the world’s largest economy.
That may be shocking to some. Especially when we’re used to seeing 2% or even 1% growth.
But it’s not the only number that can show us what’s happening in the economy.
Another figure is the Purchasing Managers’ Index (PMI). It’s a monthly survey of whether business activity is improving or weakening in both manufacturing and services.
Investors watch it because it can signal changes in growth.
For the PMI, anything above 50 means business activity is expanding. Below 50, it’s contracting.
Last week, we got a new flash PMI figure. Analysts expected it to come in around the 54 level. Instead, the reading was 58.4. That’s a huge beat. And it’s the highest reading since 2021.
So even though it may not seem like it to some, the economy is expanding. And at a higher rate than most people realize.
The Fed also said the job market is still strong. Again, a true statement. The unemployment rate is currently at 4.1%.
All this means is that, to the Fed, the job market is where it should be. And it’s one of the two mandates that the Fed has to consider when setting policy.
The other mandate is taming inflation. The Fed said that inflation remains elevated, with the recent Consumer Price Index (CPI) reading at 3.4%.
That’s actually a lower reading than when Kevin Warsh took over as Fed chair. And as I’ve argued before, the inflation rate is on its way down.
The only thing holding up inflation from falling faster is the current energy supply shock in crude oil and diesel.
We can see that’s the case by looking at core CPI – all items except food and energy. It shows the underlying inflation trend without the volatility from things like oil and gas.
Today, it stands at 2.4%. It’s lowest reading since March 2021.
Taken together, nothing is screaming that the Fed should tinker with interest rates.
So why the rate hike? Simple: bonds.
Yields Up
If you’ve paid any attention to the bond market recently, you know it feels like it’s collapsing. At least that’s the way it looks.
When the price of a bond falls, that increases the yield – or interest rate – on the bond automatically. So as yields rise, bond prices head lower.
That’s what we’re seeing happen right now in the U.S. Treasury market. And pretty much every sovereign bond market around the world.
Right now, we’re seeing the highest interest rates in benchmark bonds like the 30-year, 10-year, 5-year, and 2-year in decades. The 30-year is at its highest point since 2002. And the benchmark 10-year is above 5%. A rate it hasn’t seen since 2007.
So the argument is that the Fed had to raise interest rates to help contain the bond market. Which – if you’re paying attention – is not in its actual mandate.
But they did it anyway, ignoring any potential damage to the economy as a whole. The Fed prioritized the bond market under the guise of stabilizing prices due to the energy markets.
The thinking was yields would come down, providing relief in the bond markets. And that would eventually spill over into the price of oil.
What’s funny is former Fed chair Ben Bernanke co-authored a paper in 1997 about interest rates and oil price shocks. What he found was that much of the economic damage from oil price shocks didn’t actually come from oil. It came from the Fed’s response of higher rates.
Meaning interest rates and gas prices have literally nothing to do with one another.
The Fed knows this. But it gave them cover to raise rates to try to have an effect on the long-end of the bond market.
Yet bond yields rose anyway.
So now, it looks as if the Fed is trying to engineer an economic slowdown over fear of losing control. Control over prices they aren’t actually influencing.
Even Kevin Warsh said as much. In his press conference after the Fed’s decision to raise rates, he said, “We cannot affect any individual price, whether it be oil prices, whether it be foodstuffs at the grocery store.”
What’s Next
I think the funny thing about all of this is that if you only have a frame of reference about the bond market over the last 20 years, you’d think that we have a major problem.
But we don’t. What I believe is happening is a normalization of interest rates after years of keeping them artificially low. Including a decent stretch when the 10-year Treasury yielded less than 1%.
If you look back in history, since 1980, the average yield on the 10-year Treasury is 5.8%.
We haven’t even gotten back to the norm.
The bond market isn’t the problem. Inflation isn’t a problem. But the Fed’s response may be a problem. Especially if they hold rates too high for too long.
Now that doesn’t mean that we’re all clear. After all, we can’t discount the Fed doing something irrational. Like raising rates again despite the data saying otherwise.
The point is the current situation in the bond markets is nothing to panic about. The best thing that you can do is just be vigilant with your portfolio.
And it may even be a great opportunity to get some exposure to bonds today if you don’t have some already. Earning more than 5% interest when the dividend yield on the S&P 500 is about 1% isn’t a bad tradeoff.
Apart from that, if you use things like stop-losses, follow them. And with speculative assets like the warrants we deal with in Strategic Trader, practice solid risk management.
Don’t bet more than you can afford to lose on any one position. And take profit when the market hands it to you.
Otherwise, there’s no reason to panic. Keep calm and carry on.
Regards,
Editor, Strategic Trader