For many years, the most important market in the world – the U.S. market for money lending – was a free market. “Bond market vigilantes” made sure that the crucial 10 year Treasury yielded 2.0% - 2.5% over the inflation rate. This was true for many decades and was reflected in the yield of TIPS after they were introduced in 1997.
The Federal Reserve rarely interfered and (except for Paul Volcker) changed the fed funds rate with a light touch. Fed assets barely budged.
Ever since the 2000 tech bubble burst, the Federal Reserve has been pumping free or even negative real money into the asset markets.
After the 2001 recession, Fed Chair Alan Greenspan cut the fed funds rate and held it longer than the recovery. After the 2008 financial crisis, Fed chair Ben Bernanke cut the fed funds rate to zero and also pumped longer duration money with Quantitative Easing. Fed Chair Jerome Powell did the same during and after the Covid 2020 recession.
The money pumped by the Fed mostly stayed in the asset markets, inflating the prices of bonds, stocks, real estate and other assets (such as cryptocurrency, etc.). Companies borrowed at ultra-low interest rates. The asset markets became addicted to free borrowed money.
As all METARs know, the Fed has been raising the fed funds rate since 2022 in an effort to quell inflation. Only recently has the cost of money approached the normal free-market yield typically set by the bond market before the decades of massive Fed meddling.
By James Mackintosh, The Wall Street Journal, Aug. 16, 2023
Now things are back to what used to be normal in bonds. There was a time when the rule of thumb was that 10-year Treasury yields should be around 4%, made up of the 2% inflation target plus real yields of 2%, roughly reflecting economic growth.
That time seems to be back, more or less, with investors pricing bonds for an inflation rate of about 2.4% over the next 10 years, which with a 1.89% real yield leaves the Treasury yield at 4.2%. That real yield is also bang in line with the consensus of Federal Reserve policy makers, who expect long-term economic growth of 1.8% a year…
The risks are twofold. First, we have only just started to test the ability of the economy to withstand higher rates. This is most obvious in rising loan default rates, weaker demand to borrow and a sharp tightening of lending standards by banks. So far, only the very weakest borrowers have hit trouble…
The economy was mainlining cheap money, and the withdrawal symptoms have only just started…
If the economy has become permanently more inflationary even than it was in the 2000s, then the Fed will have to run with higher real rates to hit its target. Perhaps higher real rates aren’t about decent long-run growth prospects, but weak growth combined with deglobalization, more military spending, catch-up infrastructure investment, green subsidies and all the other inflation-inducing policies that politicians have suddenly come to love… [end quote]
The WSJ article didn’t mention the elephant in the room – the most inflationary factor of all – the immense growth of entitlement spending forecast for the next 30 years. Spending on Medicare and Social Security goes directly into consumer pockets without increasing economic productivity.
Companies with weak balance sheets (especially “zombie” companies that can barely make the interest payments on their low-interest loans) will take time to default as their debts mature and must be rolled over at higher interest rates.
The bond market is finally almost back to normal – the pre-Greenspan normal of 2% real yields. Will long-term bond yields fall when the Fed begins to cut the fed funds rate, expected in 2Q2024? That remains to be seen.
Meanwhile, the stock market is back to bubble valuations. Priced for perfection. Will it stay that way once the money junkies start tweaking? That remains to be seen.