This week Fed Chair Powell spent two days convincing the entire Senate that inflation was not a problem and it was transitory. This is despite every single consumer and producer related commodity being up in double digits and every single trader out there chasing the "inflation" trade over the past three months! After all, how can the Fed be blamed for thinking there is no inflation as clearly it never happened over the last 10 years since they embarked on this wonderful QE journey. But the Fed also did not print $4 trillion in less than a year before either, combined with every government chasing the clean and green sustainable investment to get the tick mark from their investors. The Fed has been doing the same thing each time to solve any crisis, print more money. Today we stand at a balance sheet of $7.59 trillion, and markets cannot even handle US 10year bond yields of 1.5%. It is shocking. How can we return to a normal world where yields need to be around 2.5%-3%, without an utter collapse of the system?
It is true that as economic recovery picks up, the rates and yields in the U.S. bond market need to represent that shift to reflect the improved outlook. But it is not the level that is as concerning as the pace at which it moves. No market, especially the bond markets, like volatility, and this market has been showing signs of stress over the past few weeks. Everyone has chosen to ignore this and jumped on the band wagon super cycle reflation trade - buy all commodities as there is only one way up. The reflation trade has played out very well, but it has gotten exaggerated. As speculative prices can take commodities much higher in one direction, the physical market does respond, it always does. If one were to look at the price of copper vs. gold plotted against the U.S. yields and looking at other indicators like ISM, one sees that the bond market needs to fall much more to reflect this environment, or the price of copper needs to fall a heck of a lot here vs. gold. That is how relationships work. This comes at a time when most of the world still believes in deflation and is still holding onto their long 60/40 portfolio. This portfolio made sense over the past decade as the two assets were a good hedge in "deflationary" times. But what about in inflation? Most Financial Advisors do not know how to address this, as during inflation both asset classes move in the same direction, not opposite, and that is down. Goodbye 60/40.
Long term bonds, iShares 20+ Year Treasury Bond ETF (TLT) , have collapsed nearly 15% since December 2020. This is a huge move for a market that is meant to be the most stable in the world. It is owned by pension funds and risk parity funds in trillions in size. They are now awaking to see their screens flashing as yields have exploded and their formula breaking. Inflation is not a guess, it is a certainty, once this is realized, bonds can get even uglier as the amount of institutional money that comes out can take all asset classes down, fundamentals or not. This is the power of de-risking and liquidation unwinds, called the "rate scare". The most unsuspecting person chasing the herd momentum will be the last person standing to exit with the door slammed in their faces. Technology is a great example of this "macro" tailwind, earnings aside, the reason why it had been such an easy sector to trade was because yields were only heading down throughout last year, leading to higher intrinsic values. It goes both ways, now that denominator is rising, leading to lower values.
The Fed has set an impossible goal for themselves to reach inflation of at least 2% over time and employment back to pre-Covid levels. Until then they will keep printing. Given the amount of zombie companies and permanent jobs lost, this target will never be reached. We need fiscal not monetary help. Why the need to keep buying $120 billion of bonds every month when it does not create jobs, just inflates asset prices? And with all this buying, the bond market has still collapsed. One wonders how much more they need to buy, they can never be rid of this problem. Despite Powell's claim of no inflation, the 7-year auction of the U.S. bond market had no bids yesterday and had to settle several basis points below the bid. This is the U.S. government bond we are talking about, not a dubious emerging market one!
All eyes will be on the Fed during their March FOMC meeting. It remains to be seen what they do next. As usual they play a reactive role, never a pre-emptive one, as they simply just don't know and are hopeful that the economy gets enough growth to offset inflation. If the bond market loses control, leading to chaos in broader asset classes unwinding, they might not have a choice but to embark on yield curve control. That only means more money to be printed, leading to even more inflation, just this time it will be stagflation, which is not positive for risk assets at a time the whole world is very long and levered. Because stocks can never go down, right?
