In March the Federal Reserve launched an aggressive campaign to control the worst inflation in 40 years with Chairman Powell being quoted saying “We have to restore price stability.” This was after their illusion – which they had been relating to us for months – that inflation was “transitory” finally vanished. With year-over-year inflation rates running over 8% the FED told us that it was taking action. The overnight interest rate was raised a whopping .25% - but supposedly many more interest rate hikes are en-route and the FED is going to reduce its nearly $9 trillion balance sheet. These are the mechanisms that the they have to tighten up and remove some of the ”liquidity” that has been slopping around the system since the Covid “pandemic” began.
How did the FED amass a portfolio of assets purchased in our capital markets of nearly $9 trillion? The Federal Reserve has taken upon itself the mandate to buy trillions of dollars of assets over the last 15 years to stave off the economic recessions that it engineered. The idea being if the FED keeps buying bonds, they can keep long term interest rates low to keep the economy going with borrowing and spending. They have amassed nearly $9 Trillion over the years and we are wondering – if they do stop buying all of these bonds, who is the secondary purchaser going to be? Interest rates are artificially low so we are nervous what happens when the FED pulls their buying so they can reduce their balance sheet.
The last couple weeks have been very rough for the bond market in general but particularly with the treasury market. The bonds have sold off so much so that the 40 year downtrend in interest rates is now being tested. That is a concern. There has even been talk from one of the FED governors that stock and bond investors need to endure more of a drawdown. It is the speed of the selloff in bonds that is of particular concern, just in a few weeks the 10 year treasury yield has rocketed higher and is now testing 3% which we haven’t seen since late 2018. The obvious conclusion is exactly as we feared – if the FED isn’t buying $80 billion in treasuries every month – interest rates are going to have to go higher to entice private buyers. Of course from there we start asking how much higher interest rates need to go and with these 40 year downtrends in interest rates being challenged, we fear the market volatility may be set to go much higher.
So, if the idea is that the FED is going to let the bond market stand on its own two feet and stop buying bonds – and then reduce the balance sheet, then why is the balance sheet still getting bigger? Imagine our surprise when we checked on the FED’s balance sheet and we noticed a new all-time high last week of $8.965 trillion! Of course details on what is going on will come out, but we find it a little unnerving that the treasury bond market is selling off this quickly – and it appears the FED is still buying. The good news is that the corporate bond world – and particularly the junk bond portion of it, are not selling off as if doom is imminent. We mentioned this in a previous post https://www.sesweb.net/blog/bonds-get-bombed and it is still true today. In addition to the riskier bonds actually trading pretty well, the negativity of investors is pretty bleak right now. Although that is not necessarily a good thing for how markets will trade in the near term, it does indicate that a lot of the selling has already taken place and is another indicator that doom doesn’t appear around the corner. Although we are cautious and would like to see treasury interest rates stop going up, the stock indexes are holding together reasonably well. But stay tuned cause things could change…
Regards and good investing,