The dollar’s role as dominant global reserve currency is at risk if the Fed fails to crack down on inflation.
By Wolf Richter. This is the transcript of my podcast recorded last Sunday, THE WOLF STREET REPORT.
We’ve seen the headlines in recent days. “Worst Bond-Market Drawdown on Record.” Drawdown means drop in prices. “Global Bond Market loses $2.6 Trillion,” was another one. This was based on the Bloomberg Global Aggregate Bond Index, which tracks total returns of government and corporate bonds. And this index of global bonds has plunged 11% from the high in January 2021, the biggest percentage decline in the data that go back to 1990.
The drawdown has now edged past the 10.8% drop in the global bond index during the financial crisis in 2008.
In the US, the bond market peaked in August 2020 and is now down 8.7%. The drawdown has lasted 19 months so far, the longest drawdown in the data going back to 1996.
Long-term bonds got hit particularly hard. We can see that in the iShares 20-plus Year Treasury Bond ETF, which tracks Treasury securities with 20 years or more in remaining maturities. And it being a Treasury bond fund, it’s supposed to be conservative and save. Its price plunged by 24% since the peak in August 2020.
But wait… don’t cry for bondholders. They had it so good for so long. The biggest bond bull market ever started in October 1981, when the 10-year Treasury yield peaked at 16%, and when the Volcker Fed was beginning to cut interest rates in large chunks after CPI inflation had peaked at nearly 15% and were coming down. That was the end of the worst and most brutal bond bear market anyone today can remember. And it was the era of the infamous double-dip recession.
What followed was the longest bond bull market that then turned into the bond bubble. In the US, that bond bull market, interrupted by some notable sell-offs, lasted 40 years, from October 1981 to August 4, 2020, when the 10-year Treasury yield closed at 0.52%, the lowest closing yield in history. That was the peak of the bond bubble.
In many countries, central banks pushed the bond bull market to even more ridiculous highs by cutting interest rates below zero, and using QE to push the yields of a whole spectrum of government bonds and corporate bonds below zero.
By December 2020, the total amount of global debt with negative yields reached $18 trillion, according to Bloomberg.
Negative yielding bonds are complete insanity. But that’s how far central banks went to whip the greatest bond bubble ever into frenzy through interest rate repression and money printing. Money printing means that central banks are buying bonds with newly created money, and this drove up bond prices and pushed down yields below zero percent in those countries.
And then, inevitably, came global inflation, a massive spike of inflation that just keeps getting worse and worse.
Among the developed economies, the United States CPI inflation is on top. You have to go to Brazil or Russia to get more inflation. In Russia, the central bank policy rate is now over 20%, and Brazil’s policy rate is nearly 12%. But in the US, the policy rate, the upper limit of the range, is just 0.5%.
So now the bond market is reacting to the Fed’s jawboning about its coming crackdown on inflation, which will be too little and too late, as it’s trying to engineer a soft landing.
By Friday May 25, 2022, the 10-year Treasury yield had spiked to 2.48%, the highest since May 2019. And nearly five times the yield on August 4, 2020.
But in the 16 years between 1965 to 1981, bonds got massacred as a result of huge bouts of rampant inflation that became huge bouts of double-digit inflation. Bond yields shot higher, as did the Fed’s policy rates, interrupted only by false-hope drops in yields and interest rates.
When yields rise, bond prices fall. And between 1965 and 1981, bond prices fell and fell and every rally was crushed, and rampant inflation ate everyone’s lunch.
Over those 16 years, the 10-year Treasury yield rose by 12 percentage points from 4% in 1965 to 16% in October 1981.
And it burned the bond market so badly that when the Fed started lowering interest rates in mega-cuts in the second half of 1981, the bond market said, nah, we’re not buying it, and yields remained stubbornly high for years and came down only slowly.
This was when the term “bond vigilantes” was born – meaning the bond market that had gotten clobbered and crushed over and over again in the prior 16 years had become careful, conservative, and suspicious, and wanted to be compensated properly via adequate yields for taking risks. Those kinds of scars don’t heal quickly.
But they did heal. And then in 2008 came QE, when the Fed stepped into the bond market and just bought trillions of dollars of Treasury securities and mortgage-backed securities, and the remaining bond vigilantes were mopped up, taken out the back, and shot. QE was the end of the bond vigilantes.
Interest rate repression continued, except for a three-year period from December 2015 through 2018, when the Fed raised interest rates ever so slowly and then in late 2017 started to unwind its balance sheet. By November 2018, the average 30-year fixed mortgage rate hit 5% again.
Now we’re back there. On Friday, the average 30-year fixed mortgage rate was nearly 5%, but the 10-year yield was still half a percentage point below where it had been in November 2018.
So when we read in the headlines that this is the worst bond-market drawdown in history or in the data or whatever, it excludes the 16-year bond massacre between 1965 and 1981 that gave birth to the bond vigilantes.
But here is the thing: This is just the beginning. Unlike the Financial Crisis, which was a financial panic combined with a housing bust and mortgage bust that brought the banking system to the brink, today’s problem is rampant massive global inflation, with CPI inflation in the US heading towards the double digits.
This is a huge effing problem, created in part by the Fed that printed nearly $5 trillion in the span of two years, and just now stopped printing money, despite inflation raging for over a year, and that repressed interest rates to near 0%, and just this month raised them by a minuscule quarter percentage point, and so they’re still near 0%, even as inflation is spiraling out of control. For this reason, I call it “the most reckless Fed ever.”
But the Fed has now gotten the memo. And they’re going to raise short term interest rates and they’re going to shrink their balance sheet, and they will do this a lot faster than folks imagined just a few months ago.
This is happening, and the Fed is doing it, because inflation is the biggest effing problem this economy is now facing, and will face for years.
And the Fed has shot its credibility as inflation fighter that the Volcker Fed painfully built 40 years ago, and it has instead gained rock-solid credibility as inflation arsonist, having lit this inflation fire back in March 2020 with its radical money printing scheme and then pumping gasoline on it with more money printing and 0% interest rates for two years, and it’s still pumping gasoline on it with these ridiculously low interest rates, and it will continue to pump gasoline on it, even as it jacks up interest rates by 50 basis points at a time, because CPI inflation of nearly 8% now is running away from them.
The wage-price spiral has kicked in, and trillions of dollars in excess liquidity from the money-printing binge, and from the federal government giveaways, are still floating around out there among businesses, state governments, and consumers, and they’re going to spend this money.
And the inflationary mindset is now blooming, with businesses confident they can pass on the price increases, and with consumers paying no-matter-what, and CPI inflation is heading for the double digits.
And the Fed has now acknowledged that this is the #1 problem and it’s going after it, even if it’s still too slowly.
What this means is rising yields and rising interest rates going forward, and lower bond prices, and lower home prices, and lower stock prices. A lot of assets will be repriced in this new era of much higher interest rates.
But with the Fed being so far behind the curve and still acting way too slowly, the crackdown will drag out for years, and the Fed will be chasing inflation for years, interrupted by periods of false hope, like we’ve seen between 1965 and 1980.
The period that compares to today’s situation isn’t 2018 or 2016 or 2008, but 1965 through 1981. That’s the most recent historic parallel to the rampant inflation we now have.
There is one big difference: The Fed’s toolbox has a very powerful inflation-fighter tool in it that it didn’t have back in the 1970s: its $9-trillion balance sheet. The Fed can shed part of those $9 trillion in securities by letting them mature without replacement and by selling them outright.
This Quantitative Tightening, or QT, is the opposite of Quantitative Easing, or QE, and if the Fed goes at it hard enough, it will push up long-term yields, which will raise the costs of borrowing across the board, from mortgages to junk bonds.
And so the Fed won’t have to raise short-term rates as much as it did back in 1980. If the Fed raises short-term rates to 3% or 4%, enough QT will see to it that long-term yields, such as the 10-year Treasury yield, may be in the 6% range or higher. This would mean 30-year fixed mortgage rates in the 7% range and higher. This would mean a massive repricing not only of the bond market, but also of the housing market.
If the Fed sheds $5 trillion in securities over the next few years, it will take $5 trillion in liquidity out of the market, and it will undo the psychology of the market, and it will undo the effects of QE since March 2020. And that’s a huge thing. And it will trigger a massive repricing of the stock market.
I’m not sure this will be enough to tackle this rampant inflation, but it will be a start.
And folks who made so much money since March 2020 that they decided to just day-trade stocks and cryptos, instead of working, well, with much of that wealth gone, they’re going to rejoin the labor force to reduce the labor shortage, further taking some inflationary pressures off. And that would be a good thing too.
There are some fireworks associated with QT and higher interest rates, just like there were fireworks associated with QE and interest rate repression, but in the opposite direction. If the Fed actually does this, if it has the fortitude to go through with it and take the fallout, and there’s going to be some fallout, it would calm inflation down over the span of a few years.
If the Fed doesn’t have the fortitude to do this, inflation will bloom and blossom, and the dollar’s role as dominant global reserve currency – which has been shrinking for years – will shrink a lot further, a lot faster. And the dollar’s role as dominant global investment currency will fizzle. And the dollars role as trading currency will take a serious perhaps irreparable hit. All kinds of issues will pop up that could jostle the US economy in seriously unpleasant ways.
So the Fed has all the reasons to get this inflation under control. For current bondholders, this would mean a lot more pain.
But for future bond buyers, those buying bonds with much higher yields in the future, it would mean returns where yields might even beat inflation. And borrowers would be forced by the market to actually pay bond buyers for the risks and compensate them for inflation on top of it. It would mean the end of free money. And that would be a good thing too.
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