What does the bond market say about the economy?

What does the bond market say about the economy?

A reader asks:

People say the bond market is screaming recession. Has the bond market ever been wrong? Notable examples and why was it wrong?

The bond market is known to be a lot smarter than the stock market, but we don’t have to look back very far to find a time when it got it wrong.

The bond market certainly DIDN’T see the pandemic-induced inflation coming.

Just look at where 10-year Treasury yields were coming in this year:

The 10-year still yielded only 1.5% while inflation was already at 7% and trending upwards.

The bond market was completely offside and that’s one of the reasons we’ve had such a long period of adjustment this year with interest rates.

The bond market had to reassess quickly once it became clear that inflation was going to be there for a while.

You could blame the Fed for that. They told us that all inflation was going to be transitory. He wasn’t supposed to stay at those high levels for so long.

Maybe the bond market was just getting market orders from Jerome Powell and company.

It can also be useful to understand what causes yields to vary in the bond market.

The Fed controls short-term interest rates using the federal funds rate, but things like bond supply and demand have more to do with what happens to longer-term bonds.

Then you have variables like inflation expectations, economic growth, various levers the Fed can pull, and maybe some yield trends if you’re into that sort of thing.

Add it all up and that’s why interest rates are not only different for bonds of different maturities, but when rates rise or fall, they often do so at different magnitudes across the maturity range.

You can see how this plays out with 10-year treasury bills and 3-month treasury bills over time:

They move in the same general direction over time, but often at a different pace.

3-month treasury bill yields are a good indicator of the federal funds rate, savings account rates, and CD rates. Because there is no default risk and little to no interest rate risk involved in these securities, they generally have much lower yields than longer-term bonds.

But look at them now – these very short term government debt instruments yield 0.8% After more than 10 years of cash.

This is not normal and is why many people think the bond market is screaming recession in a crowded theater.

The hard part here is for the Fed to actually invert the yield curve on purpose to stifle inflation.

It is instructive to see how different parts of the yield curve have moved over the past year to see the impact of the Fed:

Short rates went from floor to ceiling in the blink of an eye. And although long rates are higher, the move has been more muted.

It’s hard to know exactly what the yield curve is telling us, but here are some possibilities:

  • The long end of the curve doesn’t think inflation is a long-term concern, but it’s still a short-term problem.
  • Traders assume the Fed will likely have to cut rates over the next 12-18 months and call their bluff.
  • The short end of the curve is used to orchestrate a recession because that’s all the Fed can do to slow inflation.
  • Economic growth will slow in the coming months, as will inflation.

And perhaps the biggest takeaway here is the difficulty of predicting the future path of inflation, economic growth and rates.

The bond market knows everything every other investor knows (which has nothing to do with what the future holds).

My biggest reservation about using the bond market to predict what will happen with the economy is the Fed’s involvement in the market.

The Fed was buying all kinds of bonds during the pandemic to keep the financial system functioning. They have extended their welcome and the fact that they have stopped these bond purchases this year, combined with rate hikes, has made it even more difficult to understand what the bond market is telling us.

Can we really trust the bond market when it comes to the economy when the Fed is acting on so many levers?

I’m not saying we should ignore an inverted yield curve here, but the bond market shows us what the Fed is doing more than predicting what’s going to happen next.

We discussed this issue in the latest edition of Portfolio Rescue:

Alex Palumbo joined me again to talk about finding a financial advisor and how young advisors can make their way in this industry.

Further reading:
The predictive power of the yield curve

Here’s the podcast version of today’s show:

#bond #market #economy

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