The Fed finally begun its cautious taper and the market did not immediately self-destruct… but the consequences of 14 years of central bank experimentation, regulatory overkill and the ‘processification’ of markets will have consequences… they may be bleak…. When bond markets sneeze… equity markets can end up on ventilators, dragging confidence down in their wake.
Bill Blaine, Morning Porridge
[Note added on Dec. 28, 2021, when the following Patron Post was made available to all: Now that we near the year end, let’s see how the following Patron Post, written two months ago, turned out and where we go from here:]
That self-destruction coming out of the bond market probably won’t happen as a taper tantrum the second the Fed taper actually begins. Much less was it likely to happen upon the Fed’s highly anticipated announcement that it would begin tapering asset purchases. I’ve never thought that was likely, which is why you haven’t seen me put that timing on my statements that inflation will kill the stock market.
My thesis is that Inflation will cause the Fed to taper and then to tighten interest, and that actual tapering and raising of interest, not the mere news of it, is what will ultimately bring down the market. The sooner we get on with it, the sooner we get to that time. The counterpart of my thesis has always been that, if the Fed doesn’t taper or stops tapering part way through its announced plan, inflation will keep rising until inflation, itself, tears the economy to shreds along with the market that ultimately rides on the economy.
Speculative as the stock market is, testosterone-fueled sentiment is not likely to hold when inflation keeps rising, so that earnings are falling, and as GDP goes negative. The last time GDP crashed, the stock market crashed right alongside.
The Fed’s announcement, of course, could have caused a taper tantrum. That wasn’t out of the question, but it is not where I put my money. So, it’s no surprise at all that nothing happened when the Fed announced its tapering schedule. It was pretty clear to all they would, and whatever fears the market had were priced in by consolidation during the September-to-mid-October troubles in the market.
But a desert wind is coming.
Therein lies the blind spot
What I do see in the lack of any negative response to the Fed’s announcement from the stock market and the bond market is evidence of both markets’ shared blind spot — also not at all unexpected, but, in fact, something I’ve been talking about.
The Fed told us long ago (in the Bernanke era) that it was buying long-term securities in order to hold down long-term interest rates. That, if you recall, was the Bernanke plan for pumping the housing bubble back up. We’ve seen that work astronomically well. If market bubbles are what you want, the housing market is, once again, well pumped up! We now have the biggest bubble in residential real-estate prices throughout the nation in history at a time when the economy is badly faltering (affirming one of my longer-term theses, which has been that pumping up asset bubbles is a darn poor way of building true economic recovery, so the economy would fail again — in spite of, if not because of, those asset bubbles — bringing the bubbles back down with it).
Here is where simple logic steps in: If the Fed tells you it buys long-term securities as its tool for driving down long-term interest rates, then not buying those securities will allow long-term interest rates to start rising on their own again … and the housing bubble can’t afford that. More importantly, I think, the bond bubble cannot afford that. Rising interest rates in long-term bonds, equates to falling bond prices and an implosion of the big bond bubble.
I don’t think most people are understanding the most important aspect of Fed tapering. It is not the reduction in added money. That is an important factor in why market’s will collapse, but it is not the worst factor.
THE KEY: The gradual removal of Fed treasury purchases over the next six months means that within six months, treasuries will return to a market of actual price discovery. [NOTE ADDED ON DEC. 28: The Fed has already doubled its rate of tapering, as I also said in a number of posts I expected it would because inflation would be so hot on its back. That means, you already need to revise the timeframe in this post to within the next three months.] As I’ve stated repeatedly, the Fed currently buys more than half of all the treasury’s new issuances. That makes the Fed the big whale in the treasury market, which means the Fed sets market pricing. It has been keeping government interest where the government needs it.
I don’t think the Fed can have it both ways — stop buying treasuries and still manipulate interest rates on treasuries to where it wants them and the government needs them. According to Bernanke himself, buying treasuries is exactly how the Fed manipulates interest rates in a so-called “open market” operation. (Which is not really all that open when you are the sole whale in the crowd and have infinite free money at your disposal to set the market exactly where you want it.)
Over the next six months [now three months], the Fed says it will step out of that market. With every step down each month along the way, the Fed will be exerting less control over treasury yields until six months from now it will exert no control. Now, some have pointed out that the last period of Fed tapering resulted in yields falling as the Fed dropped control. Take, for example this graph, showing how bond yields fell when the Fed started it’s last big taper of QE asset purchases at the start of 2014:
What Lance Roberts of Real Investment Advice notes based on this graph is …
When the Fed does begin the process of “tapering” their bond purchases, yields historically fall as investors’ “risk-preference” shifts from “risk-on” to “risk-off.”
Yes, I see the 2014-2015 period when the Fed was tapering asset purchases, and I see that yields fell. What investors in both stocks and bonds are not seeing (their blind spot) is that the last Fed tapering happened during a time when the Fed couldn’t get inflation to rise even as it tried its hardest. Even under massive QE, the Fed couldn’t get inflation to hit its 2% goal most of time. Therefore, as bond prices turned to real-market pricing, all they had to price in was unbelievably low inflation as far as the eye could see!
If the Fed couldn’t raise inflation with massive amounts of QE, how could inflation go up with no QE? So, the market was right about that. Inflation remained flat for several more years. It didn’t change until all the shortages that came from our response to COVID turned up, creating the real COVIDcrisis economically. (And I always maintained inflation wasn’t likely to rise … until the reasons for those shortages started to appear. Since then, I’ve said keep your eye solidly on inflation as the key factor in everything about to unfold. Now all that created money chasing after too few goods has fueled the worst inflation we’ve seen in my lifetime … and it’s still rising.)
So, now, times are entirely different. Now the Fed can’t stop inflation from rising to save its existence because all that money it has printed and distributed to consumers as helicopter money via government aid and stimulus is enabling people to bid up prices during a time of extensive shortages, and the Fed cannot do anything about those shortages. You see, people have no incentive to bid up prices, even if they have tons of money, at times when abundant competition among abundant goods and services forces prices down.
So, here is the key difference: THIS TIME, bond yields (and, hence, bond prices) will be returning to real price discovery when inflation is already dictating much higher yields (interest)/lower bond prices in order to compensate for inflation. That is the opposite of the case in the past. The Fed’s extensive bond purchases across the full maturity spectrum is the only thing that has held the yield curve where the Fed wants it, but that interference in bond pricing is about to disappear right at a time when inflation that needs to be priced in is already scorching hot. That makes all the difference in the world between what happened in previous tapers or tightening and what will happen now.
What I also see in that graph is that when the Fed began actual tightening (sucking money out of the financial system via quantitative tightening in the form of rolling off its bond holdings, yields began to rise (and, hence, bond prices, to fall). That started at the end of 2017, not the middle of 2018 where the graph wrongly places it. Perhaps Roberts is referring in the graph only to the Fed’s INTEREST tightening, but the asset tightening is more closely related to what we are talking about right now and is what did the most predictable damage throughout 2018 to the stock market.
The Fed, however, is not going to tighten this time — with either interest or by rolling off bonds from its balance sheet. It will never get that far because I’m sure it remembers the painful lessons from the last time it tightened both interest and its balance sheet, hence money supply/liquidity in the financial system. Point number two to note about how this problem remains obscure is that the Fed is just backing out of “easing.” That is why many think the taper will not be a big deal.
From a money-supply standpoint, it won’t be a big deal. There is already way too much money sloshing around in the system (hence, the massive increase in reverse repos to pull some out at the other end). This, however, misses the fact that the taper means the Fed is stepping out of the bond market, which returns the bond prices to being market-driven. It is the historic nature of the bond market to price in first-and-foremost inflation. So, this time around, when bond pricing returns to real market pricing, it will have a lot of inflation to price in — the exact opposite of the financial environment last time the Fed tapered.
[Added clarification on Dec 28 to make sure no one misses the point: So the market will tighten interest rates before the Fed ever gets to that point. The Fed will have to adjust its targets just to keep up with what the market is already doing so that it doesn’t look like it’s lost control.]
There. That is the big reveal — a small point, huge in consequences because so few see it coming.
At the same time, Jumpin’ Joe’s infrastructure plan is likely to create a lot more inflation in the near- to mid-term by creating more shortages (as government projects consume more scarce resources) and by driving up labor costs by consuming more labor (good for labor but bad in terms of inflation) as the government tries to increase jobs at a time when employers already cannot find enough willing labor without boosting what they are offering considerably. Biden’s plans will require more Fed financing, pressing the Fed back into bond purchases, or drive up government interest rates on their own as the government is forced to find other buyers of its debt. His infrastructure projects are not going to resolve problems created by COVID lockdowns all over the world either. And, if he piles on corporate taxes to pay for the plans, instead of financing them, that will badly impact corporate earnings, moving the trouble for bonds prices to stock prices.
As Bill Blaine also says in the article referenced at the start of this post, “In bonds there is truth,” but that is only when they are allowed to price in truth without the total manipulation of the Fed, as we will soon see bonds doing.
Truth is going to be a big wake-up call
I don’t expect bond interest to move much at first because the Fed will still be consuming the majority of the treasury market through the remainder of this year; however, as the balance changes to where the Fed no longer has its fat thumb on the treasury scale, it’s control over bond yields will diminish to nothing, so bond prices will change to reflect real inflation expectations that have been lost entirely from bond interest rates (or yields) due to the Fed buying up the majority share of the market, pricing it where it wants it.
The big blind spot in the market all along has been that investors foolishly think inflation isn’t real or isn’t as bad as it appears because the “all-knowing, all-wise” bond market isn’t pricing any in. With incredible ignorance, they miss the fact that bonds are not pricing anything in! The Fed is pricing bonds. When the bond market is actually allowed to price things without Fed interference, the inflation picture in bond pricing is going to look ugly to reflect the ugly reality around us, and I think that will have a self-reinforcing effect throughout markets regarding inflation over the next six months. It may even become a vicious vortex where anticipation of inflation that comes from watching bond prices causes more inflation to be built into prices.
Here is just one more little thread of evidence that inflation is not settling down or proving transitory. Remember when it looked a couple of months ago like used-car prices were putting in a top. Look again:
The presumed top was a blip along the way that quickly resumed nearly straight-up trajectory. Even with new-car manufacturers finally saying the chip shortage is getting a little easier to navigate, used-car prices smashed upward an additional 9% in just one month! Used cars are in short supply because new cars are not coming on the market so old cars aren’t being traded in and coming on the market either. The promise that new cars may become a little more available should help ease used-car prices, but it was too little and too late to keep used cars from pressing upward.
Besides, the promise is a weak one that could easily be upset by more COVID shutdowns and vaccine mandates, leaving part manufacturers and car manufacturers with even fewer employees. The likelihood that hopes for decreases in any prices are false hopes is high due to Biden’s vaccine mandates, if they make it past the courts, and the reasonable likelihood that COVID still has more in store as another wave is already building in highly vaccinated Europe.
So, my main point is that the bond market has a LOT of pricing in to do when price discovery comes back into the marketplace just to catch up to what inflation is already doing and the fact that it is showing no sign of abating anytime soon and has little likelihood of abating anytime soon.
The the counterpoint there is that I am sure central banks will rush back in when markets start to crack and fear abounds and maybe even in time to prevent catastrophe … for a little while. Bear in mind, however, central banks around the world have woefully misgauged inflation so far. Every market commentator I’ve read has noted Powell is continuing to bet inflation will be transitory but is now doing his best to stretch the meaning of “transitory.” In other words, he was wrong, and he either doesn’t see it or just won’t admit it. [Update: As you saw in December, he finally HAD to admit he was wrong on the transitory claim because it became laughable to say otherwise.] Therefore, don’t think the Fed will not, due to its own blind spot with inflation, miss the mark on where it needs to taper and when it needs to taper faster [already happened] and when it needs to start raising interest. It has already missed that mark! [The Fed didn’t know that when I wrote this statement on Nov. 8 that it had already missed the mark, but it sure knows it now, which is why it doubled down on its rate of tapering QE only a month after its Nov. meeting.] Inflation is already running hotter and longer than anyone at the Fed thought it would.
Central banks all over the world are continuing to bet inflation won’t get worse when it has already gotten far worse than their original “transitory” memes. The fact that it has gotten far worse than they thought it would, seems only to convince them it must surely now be as bad as it can get. It’s not! So, there is plenty of reason to believe central banks will in consort sail past the point of no return.
We saw the Fed err’ like that greatly when it tightened in 2018, but we also saw it swing course literally 180 degrees by going from tightening back to easing within half a year because of how badly the stock market was crashing and then how the repo market came unglued when the Fed did not reverse course quickly enough even after its promised change. The Fed did not, however, swing fast enough to stop the stock market from going full bear — down 20%. The Fed’s indications of a change of course in December were, however, all it took to quell the stock market’s panic and stop the market’s avalanche.
Until such time as the Fed leaps back in with bond purchases again because it cannot stop itself from being the market manipulator-in-chief, the bond market will become increasingly real; and I think most people are not thinking about what real pricing means. They are, instead, convinced by what happened in the last big taper that interest won’t rise. Just remember that, when the Fed last stepped back from easing, it was in a near-zero inflation environment. People have never seen the Fed step back from easing in an extremely high-and-rising-inflation environment at a time when the economy is already broken due to global shortages the Fed can do nothing about and due to workers who, so far, are not ready to be enticed back to work in any great number.
In that environment, if the Fed does (as I suspect it will) return to easing or, at least, stop its taper short of ending the expansion of treasuries on its balance sheet, it won’t help because that just means inflation will keep getting hotter, which will eat at the bottom line of corporate earnings, moving the problem from bonds to stocks.
As Roberts also notes, though he retains an opposite (in my opinion blind-spot) view on bonds than I do,
Currently, with PPI at the highest spread to CPI in history, it suggests producers can’t pass on costs to customers. Such equates to weaker profit margins and earnings in the future. However, if they elect to pass those costs onto consumers, such will raise living costs well above wages.
One CEO summarized today’s financial environment as, “Inflation remains a big worry for markets, as a shortage of goods and workers is potentially dangerous for many parts of the economy, and we haven t seen a situation like this at any time in recent history.”
That is my point. This environment for Fed tapering is entirely different than the last one or than any recent time. So, do not expect things to go the same way when bonds are freed to price in the reality of the current environment. Joe’s big infrastructure projects will demand even more workers and more goods and resources to be used in those projects.
Said another CEO: “ We believe that the Fed is well behind the curve as inflation is accelerating as inflation in housing, commodities and consumer durables is causing upward pressure on wages, which will then be ultimately reflected in service sector inflation.”
Bonds are also well behind the curve in pricing that in because the Fed has had total control of bonds since its last massive round of QE began. This reality will become ultimately reflected in rising bond yields / falling bond prices to the extent the Fed finally leaves the bond market on its own.
And yet another: “I don t think the market has any ideas on which direction a policy error might come from because short-term economic conditions are increasingly raising fears of a recession.”
As noted in my last post, we are heading steeply down into recession at present, unless Biden’s infrastructure plan does the trick to keep us out; but I expect his Tax & Vax plan to do more to take us down than his infrastructure plan will do to lift us up. His infrastructure plan will certainly steepen the upward path of inflation for two reasons. It will press the Fed to return to purchasing assets, which will fuel inflation on the monetary-expansion side of the equation. It will consume more of everything, making the “too few goods” side of the equation worse. In the long term, new infrastructure MAY ease bottlenecks as the administration wants to believe, but that is too far down the road to matter right now, and is also unlikely because most of the bottlenecks at ports have nothing to do with infrastructure problems at the ports or between ports and stores. Cranes are sitting empty and not moving materials. More cranes won’t help. Trucks are waiting in line for hours to get loaded or unloaded. More roads won’t help. Containers are running out of room to be stored, but adding more storage yards, doesn’t get the products from container to shelf where things need to go.
The Fed, as I’ve said, is increasingly wedged into a trap of its own making: Keep tapering until the Fed is all out of the bond market, and bonds have a lot of ugly inflation to already price in; maintain control of bond pricing to prevent a bond bubble implosion by staying in the bond market, and inflation will keep running hotter as the Fed keeps creating too much money chasing increasingly fewer goods due to the government increasing consumption of materials and goods on its trillion dollars worth of infrastructure projects.
How bad can it get?
As treasury yields rise, they draw money out of the stock market by offering safer yields for those who buy and hold or a better prospect of selling those bonds for a profit down the road. Stocks reprice downward accordingly. As treasury yields rise, other interest rates pegged on government bonds rise. As treasury yields rise, every business with bond debt and the government, struggles more under their bond debts that they need to roll over. Zombie companies that have been financing their existence along, die. Third-world countries with large debts financed in dollars have a higher risk of default. Rising defaults bring greater risk to banks. As treasury yields rise, treasury prices fall, so bond funds loaded with bonds that are falling in value may go under.
Now, you say, the Fed will never let that happen. It will rush back in. Fine, but if it does, inflation will tear up the world even faster, and its not likely that all markets will be as complacent about Fed interference when they know it is contributing massive doses of fuel to an already roaring inflationary fire. The Fed, knowing it has no inflation room, will be reluctant and slow to return to easing, hoping markets will stabilize.
As you ponder where the stock market could wind up when this mess blows apart, here is one possible landing point to keep in mind based on the most recent points of truly hard support:
Reprinted with author’s permission from The Great Recession Blog