I have been screaming at investors for several years to stay out of intermediate and long-term U.S. bonds, as they are full of risk, while missing any type of cash return (yields) in a rising inflation environment. I wrote a bearish article in January 2022 here explaining how a bond market collapse could be reality this year. In fact, a truly weak bond market has played out. I thought I would write another explanation on why I am still worried about U.S. bond prices, despite the aggressive tightening lip-service Federal Reserve members are giving in public. With news stories trumpeting modern record 0.75% bank rate increases over the summer by the Fed, arrogance and borderline foolishness in policy is my view of the Fed's "fight" to slow 40-year inflation increases for average American citizens.
I personally do not believe the Fed is serious about bringing down the inflation rate. To be honest, Chairman Jerome Powell's comments at the last interest rate policy meeting in July are clear proof inflation will be with the U.S. for years to come. Instead of following the hardline FED member script that rates would keep rising until inflation was pushed markedly lower toward the central bank's 2% goal range, Powell backed off this pledge saying Fed Funds at 2.5% had reached a "neutral" setting to contain inflationary pressures, while only slight increases would be necessary the rest of 2022 to reverse price increases moving close to out-of-control status.
Former U.S. Treasury Secretary and president of Harvard University Lawrence Summers has been screaming for over a year, inflation rates would become a major problem for our economy. His take on Powell's comments and logic on slowing rate increases was this tepidly hawkish outlook was "indefensible." The gist of Mr. Summers' argument is Fed Funds have NEVER been this low vs. inflation in the nation's history. Below is a 70-year chart of the problem.
A new issue that may keep inflation rates higher than otherwise is the stock market's swift reaction to Powell's moderating to dovish view. Wall Street has abruptly assumed the tightening cycle is nearly over (which is far from guaranteed absent a severe recession) and sharply returned to bullish trading mode. A relief rally has materialized, pushing stock indexes higher by +15% over a span of three weeks. The added wealth effect will complicate any exit from tightening, as consumer confidence recovers.
What's scary for me to contemplate, with low but not impossible odds, is a major hurricane or two hitting the oil producing Gulf of Mexico region soon, or a new war appearing in the OPEC Middle East, or greater reductions in Russian energy supply to the world this winter could generate one final spike in oil/gas prices. If such happens in coming months, CPI rates remaining around 8% are likely, and ABOVE 10% numbers would still be within reach.
Here's why I am calling "bunk" on the Fed's lackluster inflation fight, and believe investors of all types should be leery of owning bonds until a deep recession in economic output tames the inflation beast.
First, legitimate academic studies and research since the spring have made the argument short-term interest rates are insanely too low. On the Atlanta Fed's website you can find the paper titled "The Fed's Monetary Policy Exit Once Again Behind the Curve," written by Michael D. Bordo and Mickey D. Levy, presented at the Hoover Monetary Policy Conference Hoover Institution, Stanford University - May 6th, 2022.
The most interesting part of the paper is a chart of Fed Funds vs. the Taylor Rule estimate. The Taylor Rule is an interest rate forecasting model invented by famed economist John Taylor and outlined in his 1993 study, "Discretion Versus Policy Rules in Practice." It is a history-based guide on how central banks should change interest rates to account for inflation and other economic conditions. According to Investopedia:
The product of the Taylor Rule is three numbers: an interest rate, an inflation rate and a GDP rate, all based on an equilibrium rate to gauge the proper balance for an interest rate forecast by monetary authorities.
This formula suggests that the difference between a nominal interest rate and a real interest rate is inflation. Real interest rates account for inflation while nominal rates do not. To compare rates of inflation, one must look at the factors that drive it.
Essentially, if the Fed were concerned about controlling inflation, the current Fed Funds rate would be closer to 7% using the Taylor Rule, not the present 2.5% number. So, the Fed is nowhere near a "neutral" level to slow inflation, not even in the same ballpark. If anything, Fed Funds are incredibly low and continue to ENCOURAGE price increases in the overall economy. Having "real" interest rates in the negative -6% range (adjusted for CPI inflation) on the Treasury yield curve is like nothing seen in American history since we officially left a gold standard for dollars in the early 1970s.
Second, if the U.S. Federal Reserve wanted to slow the economy and drop inflationary pressures, it could do so overnight by selling its existing hoard of Treasury purchases since the 2008 Great Recession, Quantitative Easing [QE] response began. $8 trillion in bond market interference (with total assets rising from $1 to $9 trillion) using experimental QE madness has directly subsidized federal government spending, while artificially pushing long-term borrowing costs to levels that absolutely and unfairly favor borrowers over savers. I estimate a complete exit from the Fed's balance sheet bond assets (selling into the marketplace) could increase interest rates a good 2% to 4% across the duration curve, closer to what free-market determined rates should be with 8.5% YoY CPI increases.
The Fed has reduced its balance sheet by a whopping $80 billion since April. At this runoff rate, it will take approximately 35 years to get back to a capitalistic-based free market in bond trading again, like existed before 2008. Based on 2022's lack of balance sheet action, I would argue the Fed is not remotely serious about fighting inflation.
The dirty secret for years running is the Federal Reserve actually wants high inflation to "soft" default on America's insurmountable sovereign debt mess. Fed governors were already making the argument for a policy shift in target CPI rates ABOVE 2%, before COVID-19 appeared, as a way to get sovereign debt to GDP into a more manageable range. Largely because of emergency COVID-19 economic shutdown support in 2020, at the end of 2021 the U.S. government owed more debt vs. the size of the economy than any other year in the republic's 246-year history.
Today, if the economy enters recession, there is no mathematical way to increase taxes or cut spending to balance the annual budget, much less pay back $30+ trillion in debt ($89,000 per U.S. citizen; $355,000 for a family of four) using dollars retaining a constant value. The ONLY way to keep America solvent is to repay debts in the future with paper dollars completely devalued and debased in worth. If nominal GDP rises dramatically (regardless of "real" inflation-adjusted GDP output), taxes can be collected at a higher level and incremental cuts to spending (like raising social security benefits by less than the prevailing inflation rate, which has been taking place for decades) can hopefully right the sinking financial ship.
The volume of goods and services do not have to grow, just the dollar prices paid for them. Corporate tax receipts, sales taxes, property taxes, income taxes and more are based in dollar terms. If a gallon of gas is priced at $5 instead of $2.50, the taxes generated on each fill-up transaction by consumers will double receipts for local, state and federal government agencies, all other variables remaining the same. In other words, inflation is the quickest and easiest way to help pay for the record COVID-19 debt accumulation spree.
The sad commentary on this situation is citizens "playing by the rules," living paycheck to paycheck, that do not have investments in real estate and stocks are drifting closer to poverty, no fault of their own. Last month's employment report listed hourly wage gains of +5% YoY which is a horrific standard of living number vs. inflation around +9%. The Fed's decision to inflate asset prices and the dollar point of sale for goods and services is likely a premeditated effort to keep the nation's finances afloat, sure. The argument is more people would suffer if the free market was left to work on its own, and the government was forced to balance its books. My gripe, the same as it has been since the QE nuttiness was unveiled by former Fed Chairman Ben Bernanke, is our monetary inflation process is completely unfair. The population did not vote for this monetary policy, and leaving an elite banking consortium to pick winners and losers in the economy is completely undemocratic and unpatriotic.
That's why a gold standard check on money printing and government spending is a better design. Hard money encouraged a free-market economy to deliver +4% "real" inflation-adjusted GDP growth annually for 180 years from the dollar's inception in 1792 into the early 1970s. Past generations used to witness a double in living standards over 15-20 years, and a better life for your kids was just around the corner. That's honest progress. Sadly, if you adjust for inflation accurately, the U.S. economy really hasn't grown for 40 or 50 years now, since we unchained from gold and unhinged government intervention in the economy. Working in concert, the U.S. central bank has enabled politicians hell-bent on new spending for votes. We've all been part of an experiment in modern monetary theory and fiat currency giveaways, backed by unchecked debt spending in Washington DC. Both of the major U.S. political parties are guilty of going along with the scheme.
Here's the math, and my bottom line on the situation. Assuming a no-growth economy, the 30% rise in total Treasury debt outstanding since 2019 would require a similar 30% rise in the general price level to keep debt to GDP ratios constant. So, the 15% CPI rise in total measured from early 2020 may only solve half the COVID-19 financing problem. The Fed could be shooting for another 15% climb in the cost of living, all the while talking down its impact on lives, and hoping Americans will not notice the change. That's why Quantitative Tightening [QT] is not happening (the selling of Treasury instruments held by the Fed), and short-term interest rates are nowhere near the equilibrium level suggested by the Taylor Rule. The Fed is goosing inflation, and pretending all is well. If you don't agree with their actions, too bad for you, the average citizen has zero say on the policy.
Eventually, foreigners may get upset their massive bond holdings in America are being devalued in inflation terms, and start selling Treasuries and other U.S. bonds en masse. By the way, without foreign capital buying into our merry-go-round inflation scheme, it wouldn't work, and our currency's value would implode - unleashing a dramatically higher cost of living. If this happens, capital movements out of America back to overseas investors will exaggerate our inflation problem, as they are forced to "sell" dollars repatriating capital. One of the saving graces of the past year is foreigners have been loyal troopers, willing to accept huge negative "real" yields, because the dollar's value vs. other paper currencies has actually been able to rise. Don't ask why, it doesn't make sense to me. If the U.S. Dollar Index (comparing U.S. money value to other paper currencies) had instead declined -15% vs. its +15% climb from June 2021, I estimate YoY CPI inflation would be around +11% currently! Remember, 40% of all U.S. goods have some sort of import component, after decades of globalization.
I personally have been worried something in the financial system would eventually "break" from the rotten money printing and Fed interest policy decisions over the last 12 months. The 2022 bearish action in U.S. bond and stock markets has absolutely been depressing to be a part of, but I would not categorize any of the price changes as a "break" from previous bear markets.
To me, either the U.S. dollar's value will soon hit the skids and/or longer-dated maturities in our bond market will tumble in price. To get back toward some type of acceptable equilibrium, the dollar will need to be punished for record money printing since early 2020 or long-term borrowing costs will have to accurately reflect the changed inflation backdrop. Gold and silver have been beaten down by fears of Fed tightening and the stronger dollar value against paper currency alternatives, but hard money precious metals will surely fly higher if the dollar breaks down meaningfully.
For me, the area in the financial system to avoid until the dust settles is U.S. bonds. A weaker dollar with foreigners dumping bonds would be truly bad news if you have big investments in this sector. Plus, as investors realize inflation is not going to magically retreat toward policy-stated Fed targets of 2%, Treasury yields well above the current 2% to 3% range will become the new reality, especially if the central bank is pressured to actually QT sell bonds on its bloated balance sheet.
In particular for stock market accounts, I would sell or avoid buying bond ETFs like the iShares 20+ Year Treasury Bond (NASDAQ:TLT) and Vanguard Total Bond Market (NASDAQ:BND) products. Amazingly, despite the horrible inflation setup with record negative real yields, the price level for many of these bond proxies is still higher than five years ago. Note: the below charts are adjusted to include dividend yields together with price change.
If the Fed was serious about fighting inflation for the common man/woman, it would have begun raising rates last summer (as some of us were screaming to do), while being more aggressive this year trying to match spiking month-to-month changes in the cost of living.
If the Fed was serious about fighting inflation, it would be aggressively selling Treasury securities held on its balance sheet to immediately raise long-term borrowing costs and slow economic demand goosed by all the government handouts during the pandemic.
Of course the Fed is not serious, with good reason (?). Instead, the Fed is working overtime to debase the value of each printed dollar and allow future debt repayments throughout the economy, avoiding a cascade of "hard" default disruptions and bankruptcies. Other reasons for its slow response fighting inflation include worries about tipping the economy into recession (creating a need for even greater money printing to hold inflation rates high) and the rotten math/deficit spending effect of paying higher interest costs on $30 trillion in debt for Uncle Sam.
Famed investor and former Fidelity mutual fund manager Peter Lynch, in his best-selling 1989 book "One Up On Wall Street," recommended stock market investors first buy the largest house they could afford, as a hedge against inevitable inflation. The money printing game by the Fed hasn't changed; it's just getting more out-of-control each economic cycle since America left a gold standard for dollars. I personally bought a house double the price of my family's previous home in 2016 preparing for this soft default scenario (and getting kids in a better public school system), completely unaware of approaching COVID-19 economic troubles.
I continue to believe a Strong Sell rating is appropriate for intermediate and long-dated U.S. bonds. Could I be wrong, and a recession in the second half of 2022 encourage less inflation and flight-to-safety buying in bonds? That's one possibility, however the risk of a collapsing dollar (as foreign economies are not as debt-loaded as America while experiencing far lower negative real yields on debt) and far higher interest rates in a black-swan inflation spike event are not worth it.
Versus intermediate and long-term bonds, I prefer short-term cash and money market funds, which the Fed has all but promised will provide higher yields over time until a recession hits. Selectively owning some well positioned equities is also an OK idea. Lastly, your home should continue to grow in value as it provides an excellent dollar devaluation hedge, especially if located outside of urban cores with the permanent shift to internet enabled, out-of-the-office work trends.
Food for thought anyway. If you think the Fed is on your side and serious about bringing down the skyrocketing inflation rate, you may be mistaken.
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