What is going on with the bond market? This is actually anyone’s guess. No one really knows for certain as to what is truly driving bond yields higher, but bond yields continue to push higher and higher. While there are obvious concerns about inflation and the Federal Reserve pushing interest rates higher for longer, on the one hand the moves in the bond market appear to be appropriate and in line with future expectations. On the other hand, the recent moves also appear to be exasperatingly high relative to what is actually going on.
Know this one thing: There is no ONE THING that explains all things.
Most individuals are always looking for that one magic thing that can explain all things. There isn’t. It is usually many things. And, with inflation, it is exactly that: May things have contributed to the push upward in inflation.
With regard to inflation and its outsized increases over the past few years, this is the effect, not the cause. Looking at a few things that are likely culprits in adding to inflation will enable someone to better understand what comes next with the bond market and therefore the stock market.
Inflation: The Effect, not the cause
With the COVID lockdowns worldwide, the world’s supply chain came to a screeching halt. Because of that, demands from stay-at-home US shoppers flush with new cash from stimulus checks stressed the supply chain even further. Inflation ensued.
The above chart shows the rate of inflation for both headline & core CPI inflation. The Federal Reserve initially felt that inflation shooting up like it did was transitory and that it would simply go away. It went higher. Then, in a mad rush the Fed lit up interest rates pushing them upward in the faster pace in 40 years.
It was too late to really stave off big concerns. At the same time as raising interest rates, the Fed also began letting its balance sheet to shrink by not rolling over bonds they owned, dumping these into the broader market, as well as outright selling bonds instead of holding on to them. This means that the demand for bonds has shifted with the world’s biggest printing press no longer in the business of printing paper.
Federal Reserve Balance Sheet & M2 Money Supply
Above, you can see both the Federal Reserve balance sheet and the M2 money supply. One of the big driving forces for inflation has been the Federal Reserve’s big moves in its balance sheet as well as its effects on the money supply. The Fed has shifted their own balance sheet significantly after two major events:
- The 2008 Financial Crisis; and,
Both of these events had the capability of bringing the financial system and US economy to a complete halt. The Fed stepped in to do what it could to alleviate any downside. You can see the big moves higher in the Federal Reserve balance sheets during these periods of time. And, you can also see the simultaneous moves higher in the money supply.
Now that COVID is basically no longer a threat to the overall economy, the Fed would do well to take away the measures put in place. But, it is likely too little too late.
The Fed is no longer buying US Treasury debt like it was, although the Fed will always hold some debt. This is a process of shrinking the Fed’s balance sheet. Other buyers need to step in to mop up the massive supply of paper hitting the bond markets.
The US Deficit & Supply of Treasury Debt
There are two big dips downward in the charts above:
- President Bush launching 2 simultaneous wars and the deficits created by the costs of these wars; and,
- The lack of economic activity because of the COVID lockdowns.
The US government spends too much. There is a tremendous amount of supply of paper in the system. And, while the debt-to-GDP ratio is getting more normalized, there is still too much supply of paper hitting the bond market.
Simultaneously, there is a shrinking amount of buyers for the debt. There is a really good article on The New Yorker Magazine inside the Intelligencer portion that lays out what is going on with the bond market. Very interesting read and worth some time.
In the article, the case is laid out that there is simply too much, paper, or supply of debt, that the market is demanding.
But, the Federal Reserve has its current benchmark rate for short term at ~5.50%. The long end is merely adjusting to the fact that the Federal Reserve is also not going to lower rates as soon as the market had wanted to.
For now, the long end of the curve is adjusting to the prospect that interest rates are going to remain higher for longer.
The stock market continues to be pressured
For now, the stock market is adjusting to the ‘higher for longer’ phrasing. But, the question is how much higher and for how much longer?
The US economy is still very robust, proven by the fact that the US unemployment rate is sitting at nearly-60 hear highs (3.80% at last report). The US Consumer seems undeterred in expenditures. The combination of so many people in the US being employed – and spending that money, is making the Federal Reserve very anxious. They are more likely to continue to raise interest rates if they do not see the employment numbers – a lagging indicator, soften a bit with consumption following suit. These aspects could pressure the Fed to continue to raise interest rates higher and keep them there for even longer.
Then it is a question of how long the Fed will continue to keep interest rates at higher levels, and for this the inflation rate is what everyone will be peeling their eyes toward.
Too Much Supply
In the meantime, the deficit is on trend to normalize to some level. This will allow for a normalization of the amount of supply, which this could alleviate the demand shortfall. But, it may be that the economy is transitioning out of a period of ultra-low interest rates and in to a bear market in bonds while interest rates drift higher and higher.
If the US government could trim the amount of debt being issued, that would go far in alleviating the need for interest rates to remain higher for longer as demand for smaller supply would push prices upward. At the same time, if the US consumer shrunk overall consumption – a likely factor, this will simultaneously have an effect on inflation
Finally, the shrinking of the money supply is going to have an effect on what is going on with inflation simply because a smaller supply of money means a higher rationing standard for those looking to borrow money and grow the money supply via fractional banking.
Ultimately, I see many factors driving the rate of inflation, including the supply of paper and the supply of money. Simultaneously, I see many steps being taken to contract the effects of these factors. In the meantime, the bond market appears to be in a hurry to get to a moderation level. Simultaneously, Trump’s tax cuts are having the effect of a shortfall that needs to be made up with debt. All of these factors are playing in to the drive higher in inflation as well as the push lower in stocks.
Seems the party is really over at this point and now we deal with the headaches of partying too much.