“It’s Going to Be Messy” In the Bond Market (And Stocks Won’t Be Spared)

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Perma-critic of the Fed’s QE, Richmond Fed president Jeffrey Lacker swung at it again, but this time against the markets that somehow seem to be willfully blind, or immersed in wishful thinking, when it comes to rising interest rates. Or maybe they simply can’t afford what rising rates would entail. Are they too painful to contemplate?

But they should contemplate it, Lacker suggested. Investors – and that would mostly be institutional investors – have been underestimating for months the speed with which the Fed will raise short-term rates, he told Bloomberg.

Fed funds futures contracts show that traders assign a 64% probability that the rate is going to be no higher than 0.75% at the end of 2015, while the median forecast issued in June by FOMC members puts the fed funds rate for the same period at 1.13%.

“When there is that kind of gap, it gets your attention,” he said. “It wouldn’t be good for it to be closed with great rapidity.”

It could get ugly if the market suddenly discovers that Fed Chair Janet Yellen hadn’t been kidding when she said in July during testimony to Congress that “increases in the federal funds rate target likely would occur sooner and be more rapid than currently envisioned” [Yellen Warns Investors].

OK, there were some big IFs attached, like improvements in the labor market. Investors were skeptical of the Fed’s forecast of unemployment falling to 5.7% or lower by the end of 2015, Lacker said. And these IFs is what investors have latched on to, betting that there won’t be these improvements that would trigger the dreaded words, “sooner” and “more rapid.”

Investors may also be misled by the Fed a sanguine and much repeated phrase in the policy statement that “economic conditions may, for some time, warrant keeping the target federal funds rate below levels the committee views as normal in the longer run.”

“They may be placing more weight on that than I think it deserves,” Lacker explained. “They may think we have more conviction about that than we do.”

But if investors suddenly figured out that Yellen hadn’t been kidding, and that the other Fed heads who’ve voiced similar thoughts haven’t been kidding either, and that rate hikes might actually occur “sooner” and be “more rapid,” then all heck would break lose as the bond markets adjust with a vengeance. And Lacker was worried about the volatility these adjustments would entail – “volatility” meaning sudden drops in prices.

And this volatility – these suddenly dropping prices – wouldn’t just create turmoil in the rate markets, Roberto Perli, a former Fed economist and a partner at Cornerstone Macro LP, told Bloomberg, “but also in stock and currency markets.”

As markets continue to brush off the probability of rate increases, companies continue to pile on debt at a record pace, and leverage is still ballooning in the financial system – certain aspects of which the Fed has been concerned about for over a year. And the risk of serious damage that rate increases would do to the markets is mounting.

So if the Fed funds rate rises faster than the market expects, Joe LaVorgna chief US economist at Deutsche Bank Securities in New York, told Bloomberg, “it is going to be messy.”

After more than five years of QE and ZIRP, and the all-out market manipulations and asset bubbles that came along with them, the Fed finally seems determined to end them both. QE will be tapered out of existence in October. That’s a fait accompli. And if Yellen wasn’t kidding, the end of ZIRP is next.

But investors have become viscerally dependent on the notion that rates will always remain near zero and that the Fed will continue to inflate asset bubbles, come heck or high water. Yet Yellen is the first Fed Chair in history to single out in public specific elements of our well-nurtured asset bubbles. It’s unlikely that she was kidding.

Investors won’t be prepared when these adjustments in valuations take place. Especially now, that some of these markets are increasingly illiquid, thus exacerbating the effects of any sell-offs. That was Lacker’s fear.

These asset bubbles have real consequences, including white-hot M&A activity, and tech companies are swallowing anything that isn’t nailed down. But layoffs have started soaring. And it’s getting worse. Read…. What The Heck Is Wrong with Big Tech?

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  4 comments for ““It’s Going to Be Messy” In the Bond Market (And Stocks Won’t Be Spared)

  1. Gil Obrero
    Aug 4, 2014 at 8:11 pm

    Th only possible way the fed can raise rates is AFTER they have started a war.
    Smart Investors know that.
    Otherwise it will still be still the same old same old stupidity, because reality says the US is still in recession.
    And sinking by the day, and about to accelerate.

  2. From Australia
    Aug 5, 2014 at 1:37 am

    Its going to be messy in Parliment with hangings being undertaken by the people, as they hoist their representatives to the ceilings, and burn the bloody banks!

  3. tom kauser
    Aug 5, 2014 at 9:18 am

    I remember when I was littler in the 70’s people reationalised paying double digit interest rates as a doing business cost. Sadly these folks are in no position to repeat this feat and would never go back to these times again! Leaving only bloggers to remind use of the abject horrors of yesteryear and morrofear ? Bond porn for 1 2 3 4 5 6+ years AND COUNTING DAY BY DAY

  4. Robert Leithiser
    Aug 9, 2014 at 11:25 am

    I’m just surprised that Yellen actually has the sense to keep tapering. People expected the same bubble-building philosophy of Bernanke whose main guide to policy was how high the Russel 2000 could be levitated. This is turning into a black swan for the equity markets, a ticking time bomb that will generate a deep and long lasting correction of inflated asset prices that are at least 2x too high given the economy and current value of the dollar.
    Even the FED is realizing that markets will have to correct and the only out would be making the dollar worthless and forcing the world to flee US currency as the global standard (a process which has already started). Faced with choice between extreme devaluation of the dollar that will cause even worse consequences than a falling stock market, the FED seems to be accepting the collateral damage that will occur with resumption of the US bear stock market.

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