Don't Fight the Fed, Just Ignore It

 | Aug 02, 2017 | 2:00 PM EDT
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Ever since the Lehman crisis et al caused the Fed to lower the fed funds target rate to 0-25 basis points in December 2008, the predominant meme promulgated by economic and financial market pundits has been that it would ignite inflationary and even hyperinflationary pressures that would cause long-end Treasury yields to spike. The debate among the proponents of this logic only focused on to what level yields would go, how long it would last and what the ultimate economic impact would be. 

Throughout the last decade, that meme has been a ubiquitous and constant drone behind whatever the topic of the hour or day has been for the financial media. It's always been just about to happen or, as was the case with the taper tantrum of 2013, had begun, only to not materialize, or any short jump being followed by even lower levels. 

Throughout this time period, I've intermittently written about why that expectation is wrong and that yields would eventually have to fall much further, with the 10-year breaking below 1%, the 30-year below 2% and the 30-year fixed mortgage rate below 3%. 

I continue to believe this necessary, barring some fiscal spending surge that shunts the necessity for such, which I will come back to momentarily. 

I'm not alone in expecting yields to fall further, but those making that assessment are in a very small minority. 

All my columns concerning it have been focused on the economic and financial logic requiring it, and although the yields have come close to those levels, I've been perplexed as to why they haven't achieved them yet, and years ago. 

I'll discuss what my research into that has come up with in a separate column, but one big aspect of it is the process through which monetary policy is actually transmitted to the financial sector and real economy, which I discussed a few years ago in the column, "Effective Rate Puts Fed in a Fix." 

What I'll consider briefly here is the other side of the issue; why rates haven't risen, rather than why they haven't fallen further. 

The FOMC has been promoting the narrative of increasing economic activity and inflationary concerns ever since then-Fed Chair Ben Bernanke introduced the concept of tapering the purchase of long-end Treasuries and agency mortgage-backed securities (MBS) over four years ago. 

Since the actual tapering began, and was followed by Fed rate increases, long-end yields have been in a decline punctuated by short-lived spikes. 

Separate from the economic justifications provided by the Fed -- which, if accurate, should have caused long-end yields to rise -- traders have consistently pushed the narrative of self-reinforcing long-end yield increases if threshold levels were exceeded, which I discussed at the start of this year in the column, "Reports of the Bond Bull Market's Death Are Greatly Exaggerated." 

They, too, have been wrong. 

The meme in fashion now is that the Fed actively shrinking its balance sheet will cause long-end yields to rise because the marginal buyer, the Fed, becomes the marginal seller. 

On June 14, the FOMC stated that it expected to implement a balance-sheet normalization program this year and followed that up six weeks later with the slightly more aggressive "relatively soon." 

Instead of prudently heeding the Fed's warning by front-running it with sales of Treasuries, sending yields higher, the exact opposite has happened, with the 10-year yield down about 10 basis points since the Fed first officially indicated its intention to shrink its balance sheet. 

Even more incredible is that there's been similar action in the mortgage markets, with rates, spreads and MBS showing no concern about Fed balance-sheet tapering by bankers or traders. 

Four years ago, the concept of tapering bond purchases by the Fed sent bond market participants into a tizzy based on the adage of "don't fight the Fed" as they all scrambled to sell their holdings before the Fed stopped buying them. 

Today, "don't fight the Fed" appears to have been replaced by "don't pay any attention to the Fed." 

The implications of the loss of credibility by the Fed is an issue I'll address in a separate column. For our purposes here, the germane question is what are market participants paying attention to? 

I think in the immediate, much of it is focused on the legislative problems being experienced by President Trump and the Republicans, with growing concerns about the probability of tax reform and fiscal stimulus. 

More importantly, though, is that the need for fiscal stimulus is due to the private sector's inability to create demand, as I've discussed before. 

Peak debt, which includes corporates, and exhausted consumer capacity are the issues left unaddressed publicly but which bond market participants seem to be quietly aware of

Put more succinctly, the bond markets are exhibiting an awareness that deflation is still the primary economic concern. 

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