Is the Bond Market Forcing the Fed’s Hand to Hike Faster?

Rate hike probabilities for December 2022

Half-Point Rate Hikes in May and June? 

Yesterday, I noted Half-Point Rate Hikes in May and June? That’s What’s Priced In!

A couple of my readers misinterpreted that as if the bond market was forcing the Fed. 

That’s not really what’s happening. Rather, the Fed does what it wants 100% of the time and will make excuses to get what it wants. 

If anything is forcing the Fed it’s inflation, but inflation marched higher for over a year with the market barely moving at all. 

Fed’s Primary Tool is Communication

The Fed’s primary tool is communication. If the bond market and Fed Funds Futures don’t do what the Fed wants, the Fed communicates endlessly. 

That’s why despite surging inflation, yields barely moved for a long time.

Big Swift Kick in the Pants

Recall that 50% was a 90% chance for March until a parade of Fed presidents walked it back.

There is no functioning market here. The Fed views communication as its primary tool. The market front runs Fed communication.

Recall my February 11 post The Fed Uncertainty Principle and a Big Swift Kick in the Pants

Does the Fed follow the market’s lead? Most believe so, but it’s not quite that simple.

Bullard gave the market a kick. The market responded by pricing in a 50 basis point hike for March. 

For whatever reason, Powell didn’t like it. Then a literal parade of Fed presidents walked back the hike to 25 basis points.

Does the Fed Follows the Market?

Most think the Fed follows market expectations.

However, this creates what would appear at first glance to be a major paradox: If the Fed is simply following market expectations, can the Fed be to blame for the consequences? More pointedly, why isn’t the market to blame if the Fed is simply following market expectations?

This is a very interesting theoretical question. While it’s true the Fed typically only does what is expected, those expectations become distorted over time by observations of Fed actions.

The Observer Affects The Observed

The Fed, in conjunction with all the players watching the Fed, distorts the economic picture. I liken this to Heisenberg’s Uncertainty Principle where observation of a subatomic particle changes the ability to measure it accurately.

The Fed, by its very existence, alters the economic horizon. Compounding the problem are all the eyes on the Fed attempting to game the system.

A good example of this is the 1% Fed Funds Rate in 2003-2004. It is highly doubtful the market on its own accord would have reduced interest rates to 1% or held them there for long if it did.

What happened in 2002-2004 was an observer/participant feedback loop that continued even after the recession had ended. The Fed held rates rates too low too long. This spawned the biggest housing bubble in history. The Greenspan Fed compounded the problem by endorsing derivatives and ARMs at the worst possible moment.

The Fed has so distorted the economic picture by its very existence that it is flawed logic to suggest the Fed is simply following the market therefore the market is to blame. There would not be a Fed in a free market, and by implication there would be no observer/participant feedback loop.

Fed Uncertainty Principle

The Fed, by its very existence, has completely distorted the market via self-reinforcing observer/participant feedback loops. Thus, it is fatally flawed logic to suggest the Fed is simply following the market, therefore the market is to blame for the Fed’s actions. There would not be a Fed in a free market, and by implication, there would not be observer/participant feedback loops either.

Corollary Number One

The Fed has no idea where interest rates should be. Only a free market does. The Fed will be disingenuous about what it knows (nothing of use) and doesn’t know (much more than it wants to admit), particularly in times of economic stress.

Corollary Number Two

The government/quasi-government body most responsible for creating this mess (the Fed), will attempt a big power grab, purportedly to fix whatever problems it creates. The bigger the mess it creates, the more power it will attempt to grab. Over time this leads to dangerously concentrated power into the hands of those who have already proven they do not know what they are doing.

Corollary Number Three

Don’t expect the Fed to learn from past mistakes. Instead, expect the Fed to repeat them with bigger and bigger doses of exactly what created the initial problem.

Corollary Number Four

The Fed simply does not care whether its actions are illegal or not. The Fed is operating under the principle that it’s easier to get forgiveness than permission. And forgiveness is just another means to the desired power grab it is seeking.

Inflation 2020-Present

PCE data from BEA, CPI data from BLS, chart by Mish

Would a free market in rates have ignored 7% inflation in 2021? 

US Treasury Yields 

US Treasury Yields from New York Fed

Not only did we have surging inflation, we also had QE until the announced bitter end, holding down rates!

In December, the 30-year bond yield was only 1.77% with the CPI over 7%! 

Via communication and QE, the Fed controlled rates.

Those sure as hell were not market rates.

Hikes Now?

These arrogant economic illiterates are going to do whatever they want. Nothing has changed. 

For now, the Fed has decided it wants faster hikes. The market went along. If the market didn’t go along then there would have been more communication. 

In March, Powell was then not ready for 50 basis points despite raging inflation. The result was a parade of Fed presidents walking back Bullard’s comments. 

At long last, the Fed has finally signaled it wants faster hikes.

So faster hikes are now priced in (until of course the Fed changes its mind). 

Do I think we see 2.75% to 3.25% by December? 

No, my call remains: Recession will hit first and the Fed will walk back hikes that are now priced in. 

Admittedly, I did not expect even 1.5% this cycle. Yet, for most of the last decade, it’s been correct to fade Fed dot plots of rate hike expectations. 

In case you missed it please see The Fed Uncertainty Principle because it explains what’s going on. 

Perhaps it’s finally different this time on rate hikes even though history has strongly favored the skeptics. 

This post originated at MishTalk.Com.

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Too much BS
Too much BS
1 year ago
Home listed prices are being reduced around 10%, our Lowes store has a 25% traffic and sales reduction. Like always the FED is always late to the party. Rate increase should have been done last year, The economy is cooling at this time, any rate increase now is at wrong time
Doug78
Doug78
1 year ago
The world was awash in liquidity for two decades and prices of all assets climbed. Now that liquidity is being taken away and it is no surprise that all assets decline in price. The paradox is that even taking inflation into account one of the best overall investments these last three months has been cash in dollars. It has outpaced the equity and bond markets and if we give it some more time as economies slow and demand destructs it just might outperform gold and oil.
RonJ
RonJ
1 year ago
“What happened in 2002-2004 was an observer/participant feedback loop
that continued even after the recession had ended. The Fed held rates
rates too low too long. This spawned the biggest housing bubble in
history.
The Greenspan Fed compounded the problem by endorsing derivatives and ARMs at the worst possible moment.”
Paul Krugman quoted someone who said that Greenspan needed a housing bubble, to grow the economy out of the .com bust.
Along came Bush Jr.’s (home) Ownership Society program. In 2005, Greenspan praised bankers for getting people into homes they otherwise (that Greenspan knew) could not afford. So yeah, Greenspan was purposely supporting derivatives and ARM’s at the worst possible moment, to foster a housing bubble he wanted to occur, in the first place. A bigger bubble had to replace the .com bubble. The subsequent everything bubble needed to be bigger still. And it is.
KidHorn
KidHorn
1 year ago
Something is close to blowing up in forex. Japan is totally screwed as long as the US tightens. Few will buy Japanese bonds at 0.25% when they can get much better yields in USD. This is forcing BOJ to undertake massive QE because their enormous debt can’t handle higher interest rates. And it will likely lead to other Asian countries to drive down their currency. USD and Euro may spike up while Asia spikes down. If you’re on the right side of this trade, you’ll make a lot of money, but if you’re on the wrong side, you may get margin calls and go broke. Wonder if there are any big banks on the wrong side of this.
Robbyrob
Robbyrob
1 year ago
This doesn’t look very recessionary Economic data hasn’t just been strong — they’re exceeding expectations
StukiMoi
StukiMoi
1 year ago
While no doubt right, you’re overcomplicating it.
In a free market, “downturns” results in HIGHER rates. Not lower ones.
Fewer people are willing to lend their scarce funds into a bust, than into a boom. Reducing supply of funds.
While at the same time; in a bust; more people are in desperate need of funding to stay afloat, in order to meet obligations entered into when things looked brighter. Increasing demand for funds.
More demand, less supply, results in higher prices for funds. Aka higher rates. Much higher. Much, much, much higher even. Since a self reinforcing dynamic: Of higher rates making conditions tougher; hence making lenders even more queasy and borrowers more desperate; hence making rates higher still, and so forth and so forth… Until a floor in activity is found and the malinvestment from the previous irrational boom is cleared.
The very fact that central banks have instead taken it upon themselves to force rates “lower”, despite this overwhelming dynamic; demonstrates clear-as-sky how thoroughly fundamentally economically illiterate any such institution, by simple logical necessity, will always be.
Thing is: During a boom, those who malinvest the most, are those who make the most. Hence are those who “own” the most at the peak of the boom. Hence, since political influence, like all else, is just another economic good for sale to the highest bidder like all others; these “biggest malinvestors” will always be the ones influencing policy a the peak of a boom (Biden asks Warren Buffet, not a homeless guy, for advice on what to do about “the homeless problem….”).
And for these currently wealthy malinvestors, the goal is not at all to clear malinvestment, despite that being required to make room for growth again. But rather to force others to bail out their malinvestment. Hence, since they are the ones with influence, The Fed bails them out. By forcing others to pay via massive debasement, resulting in massively economically distorting interest rates. To the point where rates are forced to move not only inaccurately, but literally in the diametrically OPPOSITE directions, from how they would move in ANY free, or even remotely free, market.
As long as you have a central bank with ANY discretion, this will ALWAYS be the case. No, “yes but if only rule,” “if only a different Fed chair,” weird “monetary policy” this and that…. about it.
In ALL POSSIBLE free markets: Irrational booms end with rates spiking, higher and higher. Until malinvestment is cleared. And hence those who benefitted from the malinvestment, who are ALWAYS the currently wealthy and powerful, are liquidated. And disgraced. Possibly hung from lampposts. Fully and completely. Without exception.
There is no such thing as a free market, where that (possibly minus the lampposts..) does not happen. In every single downturn. Free markets do not abide entrenched protected dilettante classes who just sit there idly being bailed out by the arbitrary “policy” of totalitarian state institutions effectively controlled/influenced by them. Anywhere and anytime you observe the existence and entrenchment of those, you know you are not looking at a free market. Hence not looking at anything resembling a free society. Just another totalitarian dump with no value whatsoever.
Captain Ahab
Captain Ahab
1 year ago
Reply to  StukiMoi
In a recession, both the supply of loanable funds and the demand for funds decrease. While there may be demand for funds to survive, that in itself has a different impact: what does increase is the risk premium as the risk of default increases dramatically.
With Treasury issues, there is no risk of default (theoretically), so the only factor affecting the interest rate are expected inflation and the real rate (time adjusted), which tends to be about 2% historically (long term Real GNP).
Scooot
Scooot
1 year ago
Reply to  Captain Ahab
The graph isn’t really valid because the Fed existed over that period and it’s not therefore a totally free market.
Certainly credit spreads would rise but the government borrowing requirement would rise due to lower tax revenues. Whether investors would be happy to help finance them would depend on how responsible they viewed them. They could just as easily sell the currency and invest elsewhere depending on their credit risk assessment etc.
Captain Ahab
Captain Ahab
1 year ago
Reply to  Scooot
Agreed, but Fed policy changed over the years, and those changes are fully reflected
ohno
ohno
1 year ago
What a joke.
killben
killben
1 year ago
“Perhaps it’s finally different this time on rate hikes even though history has strongly favored the skeptics.”
if it is, you can attribute it to inflation. It is all about who wins the inflation Vs recession battle. My vote would be inflation as of now. A recession will help in bringing down inflation. So recession is what the Fed probably wants
Maximus_Minimus
Maximus_Minimus
1 year ago
Let’s see, the dollar is the reserve currency. If a country holds dollars, and that stash is deteriorating by 5-10% per year, what would you do?
1. Keep the dollars.
2. Buy some commodities whose prices continue to climb.
3. Launder the dollars in the US financial system, whose value continue to climb as the dollar value deteriorates.
Captain Ahab
Captain Ahab
1 year ago
I have said before (in previous posts), the Fed ‘controls’ until it loses ‘control’. It controls by applying economic strategies and by conveying ‘information’. Since the Fed are bankers, bounded by Keynesian economics, they are not gods. When things get out of Keynesian hands, (Fed loses control) the value of the Fed’s balance sheet declines. For example, near ‘zero’-yield , long-duration bonds shed a large portion of their value when interest rates begin to increase beyond the Fed’s control.
A few tiny increases (25 basis points) are no problem, but when the market rate on those bonds should be closer to 10% than 2%, the Fed has a balance sheet disaster on its hands. It can’t afford to continue as the high priests (some might say charlatans) of the economy by taking real rates deeper into negative territory.
All games in finance and economics are won/lost at the margin. Hence the expression, Fed UP!
Casual_Observer2020
Casual_Observer2020
1 year ago
Reply to  Captain Ahab
Economic theories only work in an environment where there is a stable underlying foundation. If trade gets disrupted, or there is a war that impacts critical parts of the supply chain then nothing will really work until a new equilibrium is found. With all the stuff that has gone on since 2019, that foundation has been rocked to the core like a magnitude 8 earthquake under the ocean floor. The tsunami is about to happen and been building for some time now.
Captain Ahab
Captain Ahab
1 year ago
Actually, the free market works on any foundation (people’s individual value perceptions find equilibrium through the price mechanism); however, we haven’t had free markets since Keynes. Now, we have misguided meddling by the Fed.
JeffD
JeffD
1 year ago
There is exactly one “real” reason the Fed is hiking this time. To suppress wage growth. If there were no wage growth, they would not care about inflation. For all the reasons they talk about for hiking rates, their demeanor and tone changes only when the conversation shifts to wage growth, signalling that’s the one thing they are paying attention to in their desire to ” tamp down” the pace of inflation. I’m not being cynical. I’m being factual. The Fed is not your friend. It’s the friend of the predatory class.
Casual_Observer2020
Casual_Observer2020
1 year ago
Reply to  JeffD
The banks are mad that employees are out of control ? I think there is a case to be made that corporations are no longer in control. In order to prove they are, the large corporations need a recession and reasons to layoff overpriced workers. Big banks, big oil and the like need to maintain control.
Captain Ahab
Captain Ahab
1 year ago
The banks and corporations are evil, EVIL I say!
thimk
thimk
1 year ago
“No, my call remains: Recession will hit first and the Fed will walk back hikes that are now priced in.”
Even if inflation is persistent/escalates ?
Scooot
Scooot
1 year ago
“Do I think we see 2.75% to 3.25% by December?”
I don’t think this is likely either, even if inflation stays high. Are they likely to hike leading up to the mid-term elections? Maybe this is another reason they’re talking of front loading the hikes. Perhaps they’ll do some 75bp hikes early on but I’d say 50bp hikes are still favourite given their recent statements.
worleyeoe
worleyeoe
1 year ago
The FED will go 50 basis points in May, June & July and then will probably be forced to pause for 3 months to digest the very bad economic data that’s going to start to swell up between now and then. By August, the $95B a month runoff in QT will be in full swing. What happens after and how soon after August is anyone’s guess. Mortgage rates could be pushing 7% by then, possibly higher. The amount of food inflation is starting to be a bigger deal than home inflation, IMO. Basically, everyone who could afford a home in the last two years has bought or refi’d. Everyone else is better off sitting things out until the housing market turns by at least 10-15%. $9T is a very big noose around the neck of JPowell et al. Finally, I get tired of reading the headlines of fluff mortgage articles that ask, “What will rising mortgage rates do to house prices?” My gawd, if you have to ask that question at this point, you’re almost as out of touch as JPowell himself.
Casual_Observer2020
Casual_Observer2020
1 year ago
Reply to  worleyeoe
Yep. The business cycle is dead. We live in credit cycles (ht Peter Boockvar).
Casual_Observer2020
Casual_Observer2020
1 year ago
When the Fed went down the path of QE after the great recession there was no turning back. The economy didn’t recover any faster. They’ve never been able unwind the QE that they did and are stuck in quicksand everytime they try. I blame Bernanke and Yellen for most of this along with Greenspan. Blowing bubble after serial bubble instead of living with whatever growth the economy can produce.
MPO45
MPO45
1 year ago
Yes good post indeed but it leaves out a critical thinking point. Let’s take this statement, “The Fed, by its very existence, alters the economic horizon. Compounding
the problem are all the eyes on the Fed attempting to game the system.”
Yes, I agree 100% with this statement AND because the statement is true we can effectively say that this is action is now part of the market. The Fed has two tools: communication and raise/lower rates. The market knows this is the limit of the Fed and as stated every player in the ecosystem wants to game it. Some believe the fed will hike and invest (gamble) accordingly, others don’t believe the fed and with take positions opposite.
Fundamental questions arise. Does the Fed control the market or not? If the answer is no then what’s the point of all this? If the answer is yes, then the ONLY thing to do is to game the system. What’s the best way to game the system?
And then there is one final question, as we look around the world where there is no Fed, are these places the economic paradise that we all long for, if so where is one example of such because that’s the place money/investment should be flowing to right now.
Casual_Observer2020
Casual_Observer2020
1 year ago
Reply to  MPO45
You are mistaken when you say they have only 2 tools. They crossed the Rubicon long ago when they started QE and expanded the balance sheet. If the Fed only had 2 tools then they wouldn’t have a balance sheet. I see many tools at their disposal when I look at all the liabilities on their balance sheet. They are really just a backstop for everything that goes wrong and refuse to let anything fail.
MPO45
MPO45
1 year ago
Okay, let take what you wrote at 100% face value. The Fed is now the backstop for everything and refuse to let anything fail. The Fed seems all powerful so the only thing to do is to invest in stocks then since no company will be allowed to fail. The fed put is real and its stocks all the way. May as well sell off gold.
Casual_Observer2020
Casual_Observer2020
1 year ago
Reply to  MPO45
Stocks are the last thing not on their balance sheet. But they can control the stock market via forcing money out of bond market. This is what has happen since 2010 with QE. This a huge reason why the stock market hasn’t really suffered since except for a few blips. One was when the Fed started pulling back QE and the market went haywire and they stopped. The other was the covid drop where they again intervened. Also now the Fed is financing interest on US debt. Another new development in the last few years that has happen. Add this to the list of MBSes and corporate bonds.
MPO45
MPO45
1 year ago
So if the stock market tanks 30, 40 or 50% next week the Fed will step in and save it. Good to know…it will be a great buying opportunity.
Casual_Observer2020
Casual_Observer2020
1 year ago
Reply to  MPO45
They already have systems in place to halt trading to do that. The Fed since Greenspan keeps chasing growth and deregulation and since each crisis that was caused by growth and deregulation they keep putting backstops on failure. They keep thinking they can prevent crises when all along they are the source of the existing crisis. This is really no different than the path the Bank of Japan walked down in the 1990s and since.
Captain Ahab
Captain Ahab
1 year ago
Rational investors behave rationally. However, the risk-return tradeoff no longer exists (in a substantial way), thanks to the Fed. In a true market panic, halting trades does nothing except allow rationality to overcome panic. My guess, four or five days like Friday the mom and pop investors will stampede for the exits. All the Fed and trading rules can do it extend the pain.
worleyeoe
worleyeoe
1 year ago
Exactly, in September 2008, the FED officially adopted a MMT-based approach to managing the economy. 12 years later and one pandemic, Congress has fully jumped on board. The only last purist MMT theory that needs to transpire is for the FED to be absored into Cogress.
Casual_Observer2020
Casual_Observer2020
1 year ago
Reply to  MPO45
I can’t think of a single country where some sort of central bank doesn’t exist. Or at least one with minimal intervention. I don’t think this is possible because all central banks are an extension of the government.
MPO45
MPO45
1 year ago
So then the “market” is a system where by government and their bank extensions are the market. Good, we are making progress. We need to understand the market to either save it or profit from it.
Casual_Observer2020
Casual_Observer2020
1 year ago
Reply to  MPO45
I think this is Mish’s point. The market should be setting rates and not a central bank.
MPO45
MPO45
1 year ago
We don’t live in that world. We live in a world where we each need to survive every day. Whining and complaining about the Fed for the last 20 years has literally done nothing and accomplished nothing. Buying gold has been abysmal return wise. So now we get to the meat of the issue, where to profit?
Casual_Observer2020
Casual_Observer2020
1 year ago
Reply to  MPO45
That’s not the real meat of the issue imo. Sometimes profit is not possible. Some may disagree but this is the truth. At least it was until the Fed intervened in all kinds of things. They’ve created a shadow economy that has convinced people they can always profit in a casino.
TexasTim65
TexasTim65
1 year ago
Reply to  MPO45
Like any investment, it all depends on when you bought gold. I bought heavily during the 2008 crisis and gold doubled in a year or so for a very nice profit. It’s essentially been sideways since (at least in US dollars, in other currencies it’s appreciated nicely over the last 10 years often doubling again).
People who bought in 2002 time frame when also made out like bandits (Browns Bottom) but I wasn’t investing in gold at that time and missed it (but made OK money elsewhere).
Realist was spot on with his oil&gas call last year and he’s likely to remain right as energy prices are going to remain high for quite some time so there’s money to be made there (along with the Uranium etc).
Longer term I’m heavily invested in bio-tech because boomers and now Gen-X is aging rapidly and willing to spend their cash on prolonging their health as long as possible. I got in in 2009 after selling gold and when Obama care passed realizing there was going to be tons of money made there over the next couple decades due to demographics. But it’s a long term investment, not short term.
Roadrunner12
Roadrunner12
1 year ago
Reply to  MPO45
“Buying gold has been abysmal return wise.”
imgreen/mpo45
An 8.5% return over the last 15 years can hardly be considered abysmal.
Goldprice.org
Captain Ahab
Captain Ahab
1 year ago
Reply to  MPO45
See my earlier comment about ‘the Fed controls until it loses control’. I think we are close to that point–still not there yet. When the Fed loses control, those who game the system will get skewered. Got gold?
Scooot
Scooot
1 year ago
Good post Mish. The Fed has had an even greater impact on the market since it began QE so the bond market has had little choice but to follow the constant “heads up” communicated by the Fed.
Equities are only just beginning to listen though.
QTPie
QTPie
1 year ago

The Fed is definitely the biggest economic distorter out there. There is no better example of this than the TIPS market. The Fed distorted it so much with their interventions that it stopped making any sense whatsoever over the past year.

The best way I can describe the Fed’s actions are that they are akin to Ouroboros – the mythical snake that eats its own tail. They distorted the TIPS market to such an extent that on the face of it it was signaling no expected inflation, and the Fed was basically using the behavior of that market as one of the signals that supposedly reinforced the whole ‘transitory’ narrative – except that they themselves were the direct cause of the behavior by their actions.

It’s simply insane… about the same level of insanity that was exhibited by the Fed by continuing to purchase billions in MBSs well into an even greater housing bubble than last time.

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