What happens if federal funds rate goes above 5%?

Investment Analysis Clubs Macro Economic Trends and Risks
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Well, it becomes obvious that US Treasury bonds would get slammed.

They are not only held in great quantities by institutions of all kinds in the US, but also in great quantity by other countries. There are also a vast quantity of derivatives (like credit default swaps, but others as well).

When assets drop, some parties are forced to sell them, causing the prices to drop further and possibly forcing a liquidity crisis.

Today, the Japanese Yen hit 150 to the buck - a 32 year low - as the country struggles to keep its interest rates low in the face of world-wide inflation and rising rates.

The global financial fabric is becoming very distorted by the overlay of the consequences of the COVID responses - especially those of the US which flooded the country with piles of the world’s main reserve currency, the hangover of Brexit in the UK, further exacerbated by the recent politically motivated fiscal lunacy, the sanctions attached to the war between Russia and Ukraine and the cut in oil production by OPEC in preparation for the upcoming (pretty inevitable) global recession.

In short, there is an important reason to contemplate the expected value of a crash (even if only temporary) of US Treasury bonds on your assets and decide what the best way to address the eventuality might be.

Jeff

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That would require investors to acknowledge reality–which is what they did (even without being aware of that fact) when they put all the various products in their investment portfolio (including cash). They knew the risks. The bonds, when issued, were appropriate (to the buyers) at that time. The best they could do now is figure out if there are better investments available now.

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Jeff,

The “crash” will probably happen first months before waiting for the FED’s raising rates and the 5%.

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It’s not so obvious. That’s because of two reasons:

  1. The instant “slamming” begins, the fed can step in and buy as necessary. It’s called “providing liquidity” or whatever fancy acronym they come up with at the time.
  2. Many treasury holders are essentially almost entirely “buy and hold till maturity” investors … insurance companies, pension funds, etc. They know the yield to maturity at purchase and that is what they use in their actuarial calculations.

The derivatives are the real problem because of their huge multiplier effect. That’s why the fed will not hesitate to jump in as necessary, because once derivatives start to fail, all sorts of other things get swept into the maelstrom as well.

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Weapons of financial mass destruction, as was famously said many years back by a prior Fed chief. It is odd what is going on right now. The Fed raising rates, halting bond buying, in an attempt to slow things down and NOT be stimulative. But then the Treasury possibly buying bonds, or the possibility of the Fed buying bonds once again, directly as a consequence of them not being stimulative, is them being stimulative again while at the same time not being stimulative.

At this point I’m wondering if there is any good reason to have derivative financial products.

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My own take we need Glass Steagall back. The investment bankers need to be bankrupt if they mess up. Main street needs to be kept whole.

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A crash (a sudden, massive rise in interest rate) of U.S. Treasury bonds would be evident in the Financial Stress Index and the Corporate Bond Market Distress Index.

The Fed’s regulations state that they can only lend money (buy bonds) to AAA-rated securities (Treasuries and mortgage-backed) – except for during an emergency. In 2020, when the economy was shut down and a corporate bond emergency was emerging, the Fed established unprecedented lending facilities to less highly-rated borrowers which they shut down once the emergency was over. This was brilliant, quick action that preserved many companies, nonprofits and jobs that would otherwise have been lost.

The Fed expected losses. They were only allowed to go outside their AAA mandate because Congress voted to allow Treasury to pay for any losses that the Fed would experience. Congress didn’t renew this backup for the Fed in 2021 and the Fed closed down their emergency facilities.

We learn from this that the Fed would not act unless a true, market-destroying emergency happened where the strong would be pulled down along with the weak. The Fed is specifically prohibited from rescuing the weak unless Congress acts to allow it in an emergency.

Look carefully at the Corporate Bond Market Distress Index. Notice how all the bond ratings grouped together in 2009 and 2020, when Financial Stress peaked. However, in 2022, investment-grade bonds – the red line – is peaking way above the market and even junk bonds. Is this for real? Let’s look at the spreads, BBB (lowest level of investment grade) and CCC (highest level of junk) bonds.

As the Fed raises rates, zombie companies that can only cover their interest payments will be forced to roll over debt at higher rates. This will probably cause downgrades of some BBB companies, a serious problem since many pension and insurance funds can only hold investment-grade bonds. When dumped on the market, these ex-BBBs value will drop. Rising rates may force some CCC companies to default altogether.

The Fed obviously knows this. But they are not allowed by their mandate to rescue these weak companies unless the entire financial system is in danger. If opaque, interlocking derivatives drag down critical companies (like AIG in 2008) the Fed will step in.

As investors we will get a signal from a sudden spike in Financial Stress.

If the Fed steps in, a low-risk investment would be a bond fund. Although I generally don’t buy bond funds I did in 2020 when the Fed announced their rescue programs. When they terminated the programs I sold the bond fund which had appreciated nicely, riding up on the wave of money kindly provided by the Fed.

Wendy

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For bond investors, this is actionable information. Check your portfolio for current ratings - not just the rating when you bought the bond. And give some serious thought to getting out of any bonds that are at risk of further downgrade - while the exits aren’t crowded. Big investors like the pensions and insurers Wendy mentioned will likely stay the course. Managers there don’t want to take the loss and have it show up on their investment records. They’d rather keep riding until they have to sell and can maybe “excuse” the loss by pointing to those “lousy” rating agencies that dropped the bond to below investment grade and forced the managers to sell a “perfectly good” bond.

But the individual investor doesn’t have to answer to anyone but themselves. A loss now may be preferable to a default later, especially when the proceeds can be reinvested in a more secure company.

–Peter

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