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Cracks Are Beginning To Form In The FED’S Inflation Fighting Prowess

Longer date bond yields appear to be realizing that inflation is perhaps here to stay.  Term premium—essentially the extra compensation holders of longer term bonds require for inflation risks—has remained remarkably contained this cycle despite inflation reaching multi decade highs.

There are signs however that this is beginning to change with some extreme daily moves as the data is confirming that inflation in the US and elsewhere is more than just a “today” problem.  If bond holders are beginning to worry inflation is becoming ingrained, there are several big implications.

As noted many times, until several weeks ago longer dated Treasuries had complete confidence in the Fed’s inflation fighting prowess.  Historically longer dated debt trades 250 to 300 bps over the inflation rate thus suggesting yields should have had a “eight or nine handle” not a “three” and until today a “four handle.” 

Nominally changing topics, and writing the obvious when borrowing costs rise, governments end up paying more interest.  That fiscal blow is now landing faster than it used to.

The reason: advanced economies are in effect paying floating rates on a large chunk of the national debts—the result of more than a decade of bond purchases by their central banks…aka QE.  And with short term interest rate rising rapidly, floating rate debt has gotten expensive.

Under QE, central banks bought billions of dollars of government debt paid for by creating reserves—a kind of deposit held by banks.  With short term interest rates at zero or thereabouts, the central banks paid hardly anything on those deposits.  Meanwhile, in the US the Federal Reserve earned interest on the bonds they held amounting to almost $100 billion according to government data.

Now the dynamic has flipped.  The Fed is receiving roughly the same amount in interest but the interest they are paying on reserves has soared. 

The $100 billion the Fed earned was paid to the Treasury.  Today the interest on excess bank reserves is around $150 to $200 billion and the loss to the Fed is about $100 billion.

Writing it differently, money center banks are minting money based on Fed policy, an unintended consequence.

Yes, the government can cease paying interest on excess bank reserves as was the case pre 2008, but doing such may increase monetary velocity that will further exacerbate inflationary pressures.

As noted above, cracks are now beginning to form in the Fed’ inflation fighting prowess.  If longer dated debt experiences a comparable rise in yields as shorter dated debt, the implications could be significant.

Commenting on yesterday’s market activity, equites overcame early morning weakness and rose moderately after Atlanta Fed Bank President Raphael Bostic said the central bank could be in a position to pause rate hikes sometime late this summer.

Before Bostic’s comments, swaps show market are pricing more than 75 bps between now and June and a quarter point hike in July with a terminal rate of around 5.50%.

Bostic only confirmed the hawkish view that is now imbedded in the market with some questioning why the rally on his remarks?

What will happen today?  How will the ISM Service Index data be interpreted?

Last night the foreign markets were up.  London was up 0.16%, Paris up 0.85% and Frankfurt up 1.14%.  China was up 0.54%, Japan up 1.56% and Hang Seng up 0.68%.

Futures are up about o.25% on firmer bond prices.  The 10-year is up 11/32 to yield 4.01%.

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Kent Engelke

Chief Economic Strategist Managing Director

The views expressed herein are those of Kent Engelke and do not necessarily reflect those of Capitol Securities Management. Any opinions expressed are statements of judgment on this date and are subject to certain risks and uncertainties which could cause actual results to differ materially from those currently anticipated or projected. Any future dividends, interest, yields and event dates listed may be subject to change. An investor cannot invest in an index, and its returns are not indicative of the performance of any specific investment. Past performance is not indicative of future results. This material is being provided for informational purposes only. Any information should not be deemed a recommendation to buy, hold or sell any security. Certain information has been obtained from third-party sources we consider reliable, but we do not guarantee that such information is accurate or complete. This report is not a complete description of the securities, markets, or developments referred to in this material and does not include all available data necessary for making an investment decision. Prior to making an investment decision, please consult with your financial advisor about your individual situation. Investing involves risk and you may incur a profit or loss regardless of strategy selected. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. If you would like to unsubscribe from this e-mail distribution, please reply to this e-mail and indicate that you wish to unsubscribe in your response.