The Fed. And then the Fed steps away.
By Wolf Richter. This is the transcript of my podcast of last Sunday, THE WOLF STREET REPORT.
So now, inflation has jumped by 6.0% according to the Consumer Price Index for Urban Wage Earners and Clerical Workers, or by 5.4% according to the Consumer Price Index for All Urban Consumers. According to private sector measures, and my own estimates, inflation, when properly calculated, has jumped by a lot more.
And Americans are figuring this out because they’re seeing how the income from their labor buys less and less.
But the bond market, which is supposed to be the smart money, hasn’t figured this out yet. It too will eventually figure it out, as it did last time – that was in the late 1970s. And that’s going to be a little rough.
A year ago, the bond market put the yield on 10-year Treasury securities at around 0.6%. At the time, the narrative in the bond market was that interest rates would go negative, as they had already done in many countries in Europe.
But then, this narrative started sounding increasingly silly, as inflation began rising amid red-hot spending on goods by consumers. There was talk that the Fed would eventually taper its asset purchases, as the economy was growing in leaps and bounds. And by the end of March this year, the 10-year yield had nearly tripled, from 0.6% to 1.7%.
By definition, when bond yields rise, bond prices fall, and in bonds with long maturities, this six-month surge in yields caused some bloodletting. This was particularly felt by holders of mutual funds that specialize in government bonds with long maturities.
Since April, even as inflation became red-hot, the yield on 10-year Treasury securities dropped. By early August, it was at 1.15%, down nearly 60 basis points from the March high.
This drop in yield amid spiking inflation crushed the “real” yield, meaning the yield earned by investors minus the rate of CPI inflation.
The real yield at that point dropped to minus 4.2%. This was the worst negative real yield since June 1980, and the worst negative real yield of any of the developed economies.
The 10-year Treasury yield has since then moved up a little and on Friday closed at 1.3%, which is still ludicrously low, given that overall CPI inflation is 5.4% and CPI inflation for Urban Wage Earners and Clerical Workers is 6.0%.
So what happened in the 1970s through June 1980 that cause the real yield to blow into the negative, like it is today?
What happened was that inflation zigzagged higher and the Fed refused to deal with it. There were hopes that inflation was temporary due to the 1973 Oil Shock and would go away on its own. And after hitting 12%, inflation did back off in the mid-1970s, dropping to about 5%, and everyone thought inflation would go away entirely on its own.
But it didn’t. It turned around and spiked again, and went to 15% by 1980.
All along, the 10-year yield had zigzagged higher but had lagged years behind inflation. During that period, between 1973 and late-1980, bond investors got totally crushed, by rising yields and therefore dropping prices, and by very high inflation which for most of that time was higher, and for years, a lot higher, than the bond yield.
This was the period that became foundational for the so-called bond vigilantes that emerged in the 1980s. They were big bond-fund managers that had gotten burned during those prior years, and that then refused to buy government bonds unless the yields were high enough. And for the next 20 years, as inflation dropped and dropped, bond yields remained much much higher than inflation.
The 10-year yield and CPI inflation didn’t meet again until 2005.
But in the years when it became clear even to the bond market that inflation was going out of control, the 10-year yield spiked from 7% to 15%. Eventually the bond market figured out inflation, and then the reaction was brutal.
Before Paul Volcker became Fed Chairman in 1979 under President Carter, the Fed had already pushed up its short-term interest rate to 10%. Inflation continued to zigzag higher under Volcker who jacked up the Fed’s policy rate to 20%.
And that did the job. But the Fed had waited far too long to act, and had dilly-dallied around for years hoping inflation would go away on its own, that it was just temporary due to the one-off 1973 Oil Shock, and then the 1979 Oil Shock, and inflation kept soaring in an inflation spiral that became ingrained in the economy.
By the time the Fed finally took this seriously, and got political backing from President Reagan, it took a series of massive rate hikes to tame the inflation monster. And in the process, the nasty double-dip recession ensued, as borrowing new debt and refinancing maturing debt had become prohibitively expensive for companies.
That’s what the Fed accomplished by thinking this inflation spiral was temporary and would go away on its own. But then when it was difficult to break the back of inflation, it had to stomp on it with both feet.
So now we’ve got another supply shock, but much broader than the Oil Shock. This includes the semiconductor shortage which will soon complete its first year, and which is hitting all kinds of products, from consumer electronics and appliances to new vehicles. And there’s a container shortage, shipping bottlenecks, container port congestion, rail terminal congestion, a new vehicle shortage due to the semiconductor shortage, and all kinds of other shortages and constraints, including another major container port being closed in China due to a Covid infection.
In addition, and far more importantly, we’ve got a demand shock due to an overstimulated economy – overstimulated by trillions of dollars in government deficit spending in every direction, and by a myriad of other stimulative distortions, such as allowing tenants to not pay their rents even though many received state and federal unemployment benefits that exceeded their previous incomes; and by allowing millions of homeowners to skip making mortgage payments though many also received unemployment benefits that exceeded their previous incomes.
And much of this money that was handed out via these benefits, plus much of the money they didn’t have to spend on mortgage payments and rent, was spent on goods, thereby creating enormous and historic demand for goods. And no one was ready for this artificially stimulated demand spike. And this demand spike is now bouncing around and hitting services.
And we’ve still got the loosest monetary policies and the biggest monetary stimulus since World War 2.
This monetary policy by the Fed includes interest rate suppression to near zero for short-term interest rates, and asset purchases to the tune of $120 billion a month to repress long-term interest rates.
But the Fed is buying a lot more than $120 billion a month. It is adding $120 billion a month to its pile of securities. But it is also buying a lot of securities to replace its maturing securities.
So for example, in terms of mortgage-backed securities, the Fed is adding about $40 billion a month to its pile. But it is also buying mortgage-backed securities to replace the pass-through principal payments that it receives when underlying mortgages are paid off, which happens when houses are sold or when mortgages are refinanced.
And there has been a flood of these mortgage payoffs and refinancings. To deal with this, the Fed buys over $100 billion in mortgage-backed securities a month. Since March 2020, the Fed added $1 trillion in mortgage-backed securities. And to do this, it ended up buying over $2 trillion in MBS. The MBS market isn’t that big. And the Fed already owns a large portion of it. This is a huge interference in this market.
The Fed has also bought more Treasury Inflation Protected Securities, or TIPS, since March 2020 than the government has issued during that time. And any signals this market might send isn’t a reflection of inflation but of the Fed’s purchases of TIPS.
And the Fed has bought $3 trillion in Treasury securities on net overall since March 2020.
This massive interference is still going on despite the overstimulated economy and despite the highest negative real yields for 10-year Treasury securities in 40 years. It’s just mind-boggling.
The Fed is such a big player in that market that the market is paying attention to the market’s interpretation of what the Fed might do, and of what the market wants the Fed to do, and it’s not a reflection of inflation or economic dynamics. So all the inflation signals that this manipulated bond market is sending are wrong.
The bond market is no longer telling us anything about inflation. It’s just telling us what it thinks the Fed might do, or what it wants the Fed to do. And the bond market wants the Fed to lower interest rates into the negative and buy even more securities because that’s how the speculators with highly leveraged positions will make big gains when they sell their positions to the next one in line.
But the Fed is getting serious about stepping away from the bond market. Fed governors have been speaking in near-unison that they will taper the asset purchases, and it’s now just a question of when it starts, likely in a few months, and how fast it will go, likely a lot faster than the last taper, which stretched out for a year.
Tapering asset purchases is the first step. It means the Fed brings its balance sheet expansion to a halt.
And after the taper, the Fed will raise interest rates. Among Fed governors, there is also broad consensus on that, and it’s just a question of when it will start and how fast it will go.
And somewhere along the line, the bond market has to grapple with the reality that this surge in inflation wasn’t a one-off thing, but that inflation continues, while sometimes backing off to provide fodder for a false sense of confidence, only to surge again, as inflation normally does. It’s not linear.
And at some point, even in the current out-of-whack bond market, these realities are going to sink in. And then the bond market gets to grapple with inflation for real, and as in the 1970s, it will find itself way behind the curve, and to catch up, with the Fed no longer buying bonds, yields are going to chase after inflation.
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