Will reality return to the bond market with a vengeance?  Almost everyone including FRB Chair Powell is surprised by the two month advance in Treasuries.  As widely discussed the economy grew last quarter at annualized inflation adjusted rate of 6.5%, growth held down because of supply bottlenecks and the drawdown of inventories.  Real final sales surged by the greatest amount since 1952.

The economy added 943,000 jobs last month, prices rose over 6% in the past year and wage inflation is surging.  During this period the 10-year Treasury fell in yield from about 1.65% to 1.12% until a strong reversal last Wednesday.   As noted almost everyone would have expected yields to rise.

At the time of this writing and according to Bloomberg the 10-year is yielding 1.32% slightly higher than the pivotal and technically important 200 day moving average of 1.29%.  Yields rose yesterday for several reasons.

First was the JOLTs survey which indicated a record number of job openings.  The data exceeded the most optimistic estimate by 8.7%.  Moreover, the prior month data was revised higher.

Second a Federal Reserve sentiment survey indicated consumer’s inflationary expectations for inflation of during the next three year is at the highest level since August 2013; 3.7%.   Expectations for inflation over the next year rose to a record 4.8%.

Fed officials follow measures of inflation expectations closely because they believe them to be determinants of actual inflation.  As noted many times inflation is a two-part phenomenon…too much chasing too few goods fearing higher prices tomorrow.  It has a monetary and psychological component.

Third Atlanta Fed President Bostic stated the central bank should move to taper its asset purchases with another strong month or two of employment gains and proceed with that scaling back process faster than in past episodes.  Bostic is suggesting in the October-December time period.

The Fed is currently buying $120 billion of assets per month–$80 billion of Treasury securities and $40 billion of mortgage backed debt—and has pledged to keep up that pace “until further progress has been made toward its goals of maximum employment and 2% inflation.”

Former NY Fed President Bill Dudley stated yesterday QE has sustained the bull market beyond what is consistent with longer term fundamentals, stating further “investors would be wise to take advantage of the recent rally and take some money off the table before the Fed’s largesse ends.”

Such a change in monetary policy is tectonic.  QE commenced in 2008 and every time the Fed considers ending this massive intervention both equity and bond market volatility rises substantially.

I find some recent Fed data incredible.  Bank deposits reached $17.3 trillion last month up from $13.4 trillion in February 2020.  Excess bank reserves are almost $4 trillion, up from $1.6 trillion before the pandemic.

Wow!  With short term interest rates near zero, investors feel they have little choice but to keep buying longer dated securities.

At some juncture the Fed will start raising short term interest rates to keep inflation in check if not inflationary expectations will become unanchored.

The immediate issue at hand is the Fed pledging to keep the overnight rate at 0.00% until at least mid-2023 and the possibility of ending QE within the next three months.

Dallas Fed President made the case late yesterday afternoon for tapering more quickly and allowing to raise rates more gradually.  His exact words are

I would differentiate what our actions are going to be on the fed funds rate, from what our actions are going to be on our asset purchases.  By adjusting purchases sooner, it may actually allow us to be more patient in the future on the fed funds rate.

I ask what happens when this key support to the market ends while pledging to keep the short-term interest rates around 0.00% for the next 20 months as growth and inflation rises?  Will longer dated yields exceed intended targets?

It is scary scenario especially with the NASDAQ 100 trading at 91.56x earnings according to Bloomberg and real Treasury yields at record lows.

Last night the foreign markets were up.  London was down 0.06%, Paris up 0.14% and Frankfurt up 0.18%.  China was up 1.01%, Japan up 0.24% and Hang Seng up 1.23%.

The Dow should open flat.  The 10-year is off 1/32 to yield 1.33%.


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.