As of the week of February 7, 2022, the U.S. government and high-quality corporations still find that, for them, the bond market remains a great bargain to borrow from.
The 5-year US Treasury note is trading for a yield of around 1.75%. Expected inflation built into this nominal return over the past few weeks has been around 2.75% recently.
The bottom line is that the US government can borrow money at less than the expected rate of inflation. And, if you look at the Federal Reserve’s main statistic for the actual inflation rate, the year-over-year rate of increase in personal consumption prices, in December 2021 the rate was 4.9% and had been rising throughout the fall months. Many expect this rate of inflation to continue throughout 2022.
So, for the US government, borrowing makes sense because the real cost of money is less than zero.
This can also be seen by looking at the yield on 5-year US Treasury Inflation-Protected Securities (TIPS). Currently, the 5-year TIPS yield is slightly above 1.00%. In other words, for a large number of borrowers, issuing debt can be seen as a positive thing.
This is not an environment that could be described as “restrictive” and it is something the Federal Reserve is going to have to deal with if it really wants to fight inflation.
Much has been made of the fact that nominal yields on several of the world’s largest debts have returned to positive levels over the past two weeks.
For example, the German 10-year Bund yield moved into positive territory at the end of January, as did the yield on Swiss government bonds. Around mid-December 2021, the yield on 10-year government bonds issued by France turned positive.
And, the way things are going, it looks like those yields will now stay in positive territory. It looks like the European Central Bank will soon start raising its key rate, which will only reinforce this recent move into positive territory.
Now we only have to worry about inflation-adjusted yields moving into positive territory.
Markets out of balance
The fact that the financial markets in the United States and around the world are showing these kinds of rates is proof of the imbalance that exists within these markets. This is one of the main difficulties the Federal Reserve will have to face in the future if the Fed is really serious about fighting inflation. There are fears that the Federal Reserve is not going far enough.
The Federal Reserve announced that it would end the reduction in its monthly securities purchases by mid-March. In January, however, there was no indication that the reduction had started. This raised some concerns, particularly in the currency markets, as the value of the US dollar fell as this information became available.
Still, the Fed maintains that it will raise its key interest rate in March, once the gradual reduction is complete, and then there will be two…or more…additional increases throughout 2022.
Or else the Fed supports.
And, in the future, there will be no more sales of titles. The Fed will reduce its balance sheet, it says, by allowing securities already in the portfolio to mature without replacement. But market players do not seem totally convinced.
Jerome Powell, the Chairman of the Board of Governors of the Federal Reserve, has always been on the “timid” side of things as he has consistently conducted monetary policy in a way that errs on the side of monetary easing to avoid unfortunate mistakes.
Many fear that Mr. Powell will continue to act cautiously and as a result the Fed will always be “behind the curve” going forward, acting as a follower and not a leader.
The concern is that if Mr. Powell and the Fed act in this way, it will only lead to further disruption due to the imbalance that already exists in the market.
Since September 1
The current position of the Federal Reserve really began around September 1, 2021. Around September 1, the Federal Reserve decided to hold its key interest rate, the federal funds rate, constant at 0.08%. The reason for this action was that the Fed was pumping so much money into the banking system, buying $120.0 billion worth of securities, plain and simple, each month that it had to act in a way to maintain the effective federal funds rate. in positive territory.
Mr. Powell and the Fed did not want the fed funds rate to go negative. The Fed used reverse repurchase agreements to keep the rate stable.
As we can see on the following graph, the Fed has done a very good job.
The Federal Reserve has said that going forward, it will focus on the federal funds rate as its primary policy tool. So this rate is obviously a very important rate to watch in the future. But, it will also be very important to see what the Federal Reserve does to maintain interest rate policy in its efforts to fight inflation.
Rising interest rates
Since the Federal Reserve has been talking about “reducing” its monthly securities purchases and moving to a higher key interest rate, market rates have risen. Here we look at the difference between the return for September 1, 2021 and last Friday. The yield on the 2-year US Treasury note rose from just over 0.20% to over 1.30%. The yield on the US 5-year Treasury note rose from just under 0.80% to around 1.75%. And the yield on the 10-year US Treasury fell from around 1.30% to just under 2.00%.
Note that the actual returns behind these results have also increased over this period, but not as much. For example, the yield on 5-year TIPS fell from minus 1.85% to minus 1.15%. Thus, “real” yields have increased along with nominal yields, but not as much.
These need to turn positive before the Federal Reserve can truly say it is fighting inflation. The US government and blue chip companies will still be able to benefit from inflation, given this relationship.
Thus, this would indicate that the nominal yield on the 5-year US Treasury would need to rise to around 3.00% for the real yield to move into positive territory.
Given this fact, the Federal Reserve would still be “behind the curve” for some time this year. In other words, the Federal Reserve, over the last couple of years or so, has created such unnerved markets that “catching up” with them is going to be a real chore, something Powell may continue to lag behind. .
As I have written before, the year 2022 will be a very difficult year with relatively high inflation rates, rising interest rates and imbalanced markets. Not a pretty sight to be expected.