Bonds are feeling a bit gothic.

These days, the bond market reads like a bad movie sequel to a pure classic.

A lot like Mary Shelley’s Dr. Frankenstein who sought to galvanise perfection from cobbled together body parts only to create a monster - so too did U.S. Fed Chairs Bernanke and Powell use QE to shock broken markets after the GFC and COVID-19, only to create the most inflated asset markets there have ever been.

Massive bolts of liquidity, loan backstops and a guarantee to prop up the monster, should it show signs of falling to pieces.

But after 12 years of living with that distortion which now needs ~$120 billion every month to stay alive, it continues to get bigger while interest rates move lower. And, a run-off or taper is years away.

There is little doubt that further bond buying, yield curve targeting, deficit financing and welfare chimney money (from treasury) must occur and that means rates will go lower for longer. And because of Fed Chair Powell’s dislike of negative interest rates, it may be that the Fed starts to target the back end of the curve.

What that means is that the Fed is now the bond market. And the bond market is now the Fed.

That’s why we should be careful using bond market data to interpret what’s going on in the real economy, because we might just be getting what the Fed wants you to see, and that’s not necessarily real.

Yield curve targeting.

Fed Chair Powell says he will run the economy hot by injecting ample liquidity into the banking system (through bond purchases) in the hopes of more lending, investment and money velocity as well as full employment and 2% plus inflation.

To achieve this, he has so far pretty much targeted the shorter end of the yield curve and managed nominal yields down to 0%.

At the 10 year and 30 year points, yields are just under 1% and 1.84% respectively, so his strategy might be about to change. His choices are:

let short rates go horribly negative (currently short real yields are negative but nominal yields are positive);
start to target the longer end of the curve, e.g., 10 year, and then 30 year treasury bonds where he has nearly 2% yield to play with;
target both ends and the middle to bring the entire curve down, while keeping it slightly pointing up to the right.

We will have to wait and see.

The Fed is the Bond market. The Bond market is the Fed.

It used to be that companies and governments would use treasuries like an overdraft to park excess cash, or to sell and raise finance. Traders and speculators used it to profit. Banks used it for collateral lending. Investors used it as collateral or to protect equity downside risk and to park lazy capital.

And the Fed used it sparingly to influence interest rates down (by buying) or up (by selling) for short periods, with a promise to put those emergency tools away once the emergency passed.

But it never really put them away, and while today U.S. T bonds and notes are still used for some of the above, the market is dominated by purchases from Fed for QE Infinity purposes.

Until the Fed can work out a way to taper/reduce its holdings without causing an irreparable meltdown in secondary asset markets, it won’t be a good barometer of the economy, and it will show false positives when it comes to non-Fed inflationary expectations.

So, what does that mean?

Inflationary expectations are now the Fed’s expectations, not yours and mine.

The read on inflationary expectations that we would normally get by subtracting inflation adjusted bonds from ordinary bonds (i.e., the breakeven inflation rate) may no longer be helpful.

The current curves show the 30 year bond trading on a yield to maturity of 1.84%. The orange line is the breakeven rate and for some time now has been higher than nominal bond yields because inflation adjusted bonds are negative, and currently trading at -0.30%.

And, the 30 breakeven inflation rate of 2.14% is only a shade above the 10 year breakeven inflation rate of 2.08%.

This tells us that the 10 to 30 years average annual inflation expectation is a shade over 2%.

But as mentioned before, this is most likely a Fed distortion resulting from its controls of the short end of the bond market, which in turn has pushed investors further out to 30 years where there is still some yield to be had.

It’s those Fed interventions and not the real economy that is distorting yields and inflationary readings. IN other words, it’s no longer a free or ‘non-anxious and willing’ market, it’s Fed guidance.

And if those non-Fed investors sniff an opportunity for 30 year yields to fall and the value of their paper (the price of a bond) to increase, they will sell to the Fed and tip the proceeds into high yield corporate bonds and then equities and/or crypto.

And then we will see even more ridiculously overvalued monsters being brought to life somewhere else along the risk curve.

For the first time in 40 or so years as short bond yields go to zero and negative and longer term yields flatten, the bond market may not be as helpful to read the real economy and inflationary expectations as it once was. It’s now the Fed’s laboratory, and false positives on inflation that lead people to think the world is reflating, are also likely to be fake.

And it seems like there’s a lot more distortion to come.

As of last Thursday, the Fed holds $7.4 trillion in bonds, mortgage backed securities and other paper (out of a $40 to $50 trillion bucket) with an additional annual $1.4 trillion being purchased on remote control – and all of this in light of a $3.2 trillion government deficit that will need to be partially or fully funded by new bonds, plus further shortfalls from COVID.

If the Fed becomes the buyer of those new bonds as well, you can easily imagine its already monstrous balance sheet exceeding $10 trillion this year (12 times higher than at the peak of the GFC response) and the entire curve being deep-sixed below the x-axis.

And to help think about how much more bizarre and distorted the financial math might get, here’s something that Janet Yellen, the recently confirmed first woman Secretary of the Treasury and ex Fed Chair said last week of now President Biden’s $1.9 trillion relief package:

“Neither the president-elect, nor I, propose this relief package without an appreciation for the country’s debt burden. But right now, with interest rates at historic lows, the smartest thing we can do is act big. In the long run, I believe the benefits will far outweigh the costs, especially if we care about helping people who have been struggling for a very long time.”

Incidentally, U.S. national debt is currently $28.6 trillion.

The point is that a lot of new bond issuance and Fed bond buying will need to occur purely for welfare and budget deficit purposes, i.e., keeping the lights on money, and then the vaccines will need to do their job before the government can think about thinking about pulling the fiscal growth lever, if it still knows how.

In the meantime, it may be that the Fed has to: (a) go to negative yields at the short end, (b) target the long end of the curve where there is some fat, so that the front end does not go too negative, or (c) engage in both and bring the entire curve below the x-axis.

Given we know Powell is not a fan of negative rates, the second option sounds more feasible, plus the 1.84% fat at the back end of the curve looks ripe for picking, and if that’s where the lightning will be channeled the entire curve will be as flat as a mortician’s slab and Frankenstein’s monster will find not one, but several brides.

Or, market participants will revolt and break the Fed’s strategy.

Pleasant dreams comrades.

Mike.

The Fed might be about to cobble another monster

Bonds are feeling a bit gothic.

Yield curve targeting.

The Fed is the Bond market. The Bond market is the Fed.

Inflationary expectations are now the Fed’s expectations, not yours and mine.

And it seems like there’s a lot more distortion to come.