The Bond Market Isn't Buying the Fed's BS

Written by Jason Simpkins
Posted March 5, 2021

You may have noticed the bond market has garnered some serious attention over the past few weeks. 

So serious, in fact, that FOMC members and the chairman himself even felt the need to try and play down concerns. 

Nevertheless, we're seeing broad dislocation between the bond market and the Fed's wishes.

And one reason for that is that the market sees through the Fed's lies and denialism regarding inflation.

You see, the problem kicked off in earnest in February when a wave of selling drove the yield on the benchmark 10-year Treasury note to its highest level since the pandemic began.

The rate, which helps set borrowing costs on corporate loans, home mortgages, and other debt, shot above 1.5% — its highest level since the pandemic began and up more than 160% from its August low.

Now, just to be clear, as with any yield, it moves inversely to bond prices themselves. That is, yields spike when demand for debt plunges and bond prices drop. 

And that's certainly been the case for Treasuries of late. 

Last Thursday, demand for 5-year and 7-year Treasuries was especially weak heading into a $62 billion auction, as the 7-year note sold at a 1.195% yield, or 0.043% higher than expected — a record gap for a 7-year note auction.

Furthermore, the large financial firms that trade directly with the Fed and are required to bid at auctions were left with about 40% of the new notes — twice the recent average.

So why is the market so unwilling to gobble up the Fed's bond buffet? 

Well, one answer could be inflation. 

It almost goes without saying, but if prices are going up, the fixed return on long-term bonds becomes a lot less appealing because it's losing value in real time.

And prices, as we discussed last week, are in fact going up. 

That's not something the average investor would necessarily believe if they're simply tracking the Fed's "preferred" measure of the core CPI. But it's an obvious truth to anyone who's been buying groceries over the past year or is looking to buy a house. It's also obvious to commodities traders who have seen massive surges in the prices of oil, lumber, corn, and copper to start the year.

It's also apparent if you look at the yield on 10-year Treasury inflation-protected securities (TIPS), which climbed roughly 6 basis points on Wednesday, compared with a 3-basis-point increase for the traditional 10-year bond.

Incidentally, the 5-year "break-even" rate — the difference between the yields on 5-year Treasuries and 5-year TIPS — has climbed to hit 2.4%. That's the highest since May 2011. It suggests the market anticipates inflation will be running ahead of the Fed's old 2% target in five years' time. 

But here's the thing about that: The Fed has already thrown that old 2% target out the window. That's something I covered last summer.

“I am hard-pressed to think of reasons why we would need to move away from accommodative monetary policy unless inflation was well above 2% for an extended period of time, and the economy was just very different from what we are seeing right now,” Chicago Fed President Charles Evans said at the time. 

Not surprisingly, Evans thinks rising bond yields don't have anything to do with inflation, but are instead indicative of economic optimism.

The surge in yields is “because of real factors — the vaccine rollout seems to be going up, everybody would like it to be a lot quicker, it seems to be going reasonably well, and that means that the rebound in growth should be that much better,” Evans told reporters.

The obvious implication there is that inflation, apparently, isn't "real."

What a pleasant fiction. 

Again, it certainly seems real to bond traders, not to mention the average American.

But even if we take Evans at his word, that's revealing in its own way. 

That is, another reason investors might not buy long term-bonds is because they think the Fed will have to raise rates sooner rather than later. That seems self-explanatory. Why buy bonds with low yields if you can wait six months or a year and get a much higher return?

However, the Federal Reserve has been adamant that it's not going to raise rates anytime soon. And it's chosen instead to completely ignore the persistent knocking of inflation until the very point it kicks down the door. 

So in this scenario, the economy recovers so strongly (and, miraculously, without inflationary pressures) that it overheats, forcing the Fed to raise rates.

But it still casts doubts on the Fed's credibility. 

Either the market thinks the Fed is wrong about inflation, or the market thinks the Fed is wrong about its timetable for rate hikes. 

Either way, the market thinks the Fed is wrong. 

And I do too.

Fight on,

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Jason Simpkins

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Jason Simpkins is Assistant Managing Editor of the Outsider Club and Investment Director of Wall Street's Proving Ground, a financial advisory focused on security companies and defense contractors. For more on Jason, check out his editor's page. 

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