We’re soon going to find out where the Fed’s pain point lies. Treasury yields on the long end of the curve have been relentlessly pushing higher this year with the 10-year treasury pushing past 1.5%, all while pressures within the plumbing of the money markets and repo are pushing into negative territory. Quite the mix of pressures being applied to the markets right now! I think we’re very close to the make or break point for the Fed. They’ll need to act on both ends or else markets will be become increasingly volatile.
The long end rising is putting pressure on stocks, mainly from de-grossing of exposure by risk parity funds right now, but also the longer-term implications of higher yields: higher interest expense on over-indebted companies, lower valuations within stock pricing models (especially growth stocks), bonds become more attractive on a comparative basis, etc. These latter effects have a longer lag time before hitting companies on a fundamental basis but there are bigger issues in the short-term that I think the Fed is keenly focused on and will ultimately force their hand. They are:
- A falling stock market quickly translates into reduced spending in the real economy (the effect of financializing our economy over the last decade plus)
- 30-year mortgages are generally priced off of the 10-year treasury yield. Higher mortgage rates will slow the housing market with the busiest season for buying/selling houses right around the corner. Recent mortgage data is already showing a slowing.
- The 800-pound gorilla: the government is already in an untenable fiscal situation and a rising interest expense only compounds that problem. Not to mention that they’re going to need to suppress yields below inflation (negative real yields) for at least the next decade.
The Fed has been floating trial balloons about yield curve control (YCC) as a possible policy tool for 18 months now and over the past week they’ve been denying the need for it, which means they’re close to implementing it. I think we’re soon going to find out where their pain point is. Is it with the 10-year at 1.5%? 2%? Is it after the S&P 500 falls 10%? We’ll see. If they don’t implement it, the 10-yr yield will likely rise to 3% or 4% which would cause the economy and stock market to both roll over hard. Bonds down, stocks down, gold down. It would be the ultimately deflationary bust scenario that they’ve been trying so desperately to prevent from happening. So yeah, they’re going to implement it.
I guess that’s the problem with artificially supporting asset prices by injecting liquidity into markets via QE: markets become dependent on it or else bad things happen. Instead of letting market prices properly clear, the Fed is trapped and their hand will be forced. YCC is not a stated amount of monthly purchases though – it’s an open-ended amount. They’ll have to buy whatever is needed to match selling to keep yields from rising. I wouldn’t be surprised to see the Fed’s balance sheet at $40 or $50 trillion within 5 years.
I also expect inflationary pressures to persist this year so if some form of de facto YCC is announced, we’ll likely see hard assets take off like a rocket. I’d be willing to bet we ultimately see real yields (i.e. adjusted for inflation) touch -4% or lower in the years ahead.
Below is a chart of the price of gold (red) vs. 10-year real yields (blue). This should illustrate why gold is a must have hedge against the Fed keeping yields suppressed below the rate of inflation (YCC is a form of financial repression) for any portfolio with a more conservative income focused tilt to it.
Thanks for following,
-Nick