The reader asks:
People say the bond market is in a recession. Has the bond market ever gone wrong? Any notable examples and why it went wrong?
The bond market is known for being much smarter than the stock market, but we don’t have to go back very far to find a time when it was wrong.
The bond market certainly did NOT see the pandemic-induced inflation coming.
Just look at where 10-year Treasury yields have been this year:
The 10-year yield was still only 1.5%, while inflation was already 7% and rising.
The bond market has been completely offside, and that’s one of the reasons why we’ve had such a big rate adjustment period this year.
The bond market had to hastily re-price when it became apparent that inflation was here to stay for some time.
You could blame it on the Fed. We were all told that inflation would be temporary. It shouldn’t stay at these high levels for that long.
Maybe the bond market was simply taking orders from Jerome Powell and company.
It can also be useful to understand what causes changes in bond market yields.
The Fed controls short-term interest rates with the Fed Funds Rate, but things like the supply and demand for bonds have more to do with what happens to long-term bonds.
Then you have variables like inflation expectations, economic growth, different levers the Fed can pull, and maybe some yield trends if you’re into that sort of thing.
Add it all up, and this is why interest rates not only differ for bonds of different maturities, but when interest rates rise or fall, it often happens by different magnitudes across the maturity spectrum.
You can see how this plays out with the 10-year Treasury and 3-month Treasury bills over time:
They move in the same general direction over time, but often at different speeds.
3-month Treasury bill yields are a good proxy for the Fed funds rate, savings account rates, and CD rates. Because these securities involve zero default risk and little or no interest rate risk, they typically have much lower yields than longer-term bonds.
But look at them now – these extremely short-term government debt instruments are yielding 0.8% more than 10-year Treasuries.
That’s not normal, and that’s why many think the bond market is screaming recession in a packed theater.
The hard part about this is that the Fed is actually inverting the yield curve on purpose to stifle inflation.
It’s instructive to see how different parts of the yield curve have moved over the past year to see what kind of influence the Fed is having:
Short interest rates went from floor to ceiling in the blink of an eye. And while long-term 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 believe inflation is a long-term concern, but it’s still a problem in the short-term.
- Traders speculate that the Fed will likely have to cut rates in the next 12-18 months and are calling their bluff.
- The short end of the curve is used to orchestrate recessions 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 is how difficult it is to predict the future path of inflation, economic growth and rates.
The bond market knows everything that every other investor knows (which is nothing about what the future holds).
My biggest gripe with trying to use the bond market to predict what will happen to the economy is the Fed’s involvement in the market.
The Fed has been buying all kinds of bonds during the pandemic to keep the financial system running. They’ve overstayed their welcome, and the fact that they’ve stopped those bond purchases this year, combined with interest rate hikes, makes it even harder to understand what the bond market is telling us.
Can you really trust the bond market when it comes to the economy when the Fed is pulling so many levers?
I’m not saying we should ignore the inverted yield curve, but the bond market is more about showing us what the Fed is doing than predicting what will happen next.
We discussed this issue in the last edition of Portfolio Rescue:
Alex Palumbo joins me again to talk about finding a financial advisor and how young advisors can make their way in the industry.
The predictive power of the yield curve
Here’s the podcast version of today’s show: