When Will the Fed Be Forced to Quit?

October 13, 2022

As we have mentioned many times before, you can’t raise interest rates in a bubble economy.  All of our asset prices, stocks, real estate and bonds, have been re-priced to a much higher level due to low interest rates.  Raise those rates and the asset values have to fall, which, in a bubble economy, can eventually precipitate a price collapse. 

Also, if the Fed stops printing money, which is the way the Fed raises interest rates, we will not have enough money to fund our massive government borrowing which is key to maintaining our economic growth. 

Despite all this the Fed has engaged in a great battle to raise rates in an attempt to control inflation.  However, for the above reasons it will be forced to quit.  The only real question is when. 

The likeliest problem to hit the Fed first is an asset price collapse, rather than an economic problem like a recession or high unemployment.  It could take months for the economy to deteriorate enough to force the Fed to quit – many months. 

However, asset prices can decline very quickly, especially now that they have already declined quite a bit this year.  Since real estate is fairly illiquid, the biggest problems are likely to show up first in the stock and bond markets, which are much more liquid.

The Bond Market is the Most Important Market for the Fed

Of the two markets, the Fed will be more sensitive and quicker to react if there is a problem in the bond markets.  They are actively involved in the bond market since that is how they control interest rates. 

Bond markets look peaceful on the surface right now but the quick eruption of problems in the British bond market a couple weeks ago reminds us of how quickly the bond market can change. 

So, let’s look a little below the surface of the bond market.  One way to do that is to look at the MOVE index.  It is a volatility index for bonds like the VIX is for stocks. As volatility goes higher, the bond market is seeing more stress.  Currently the MOVE index is at historic highs having moved from 68 a year ago to as high as 160 in the last couple weeks.  It has only been higher than 160 during the peak of the Financial Crisis in September and October of 2008.

The Bond Market Is Likely to Be the First to Feel Stress

There are other signs of problems in the bond markets.  Traditional buyers of US Treasury bonds, including US banks and foreign central banks are stepping back from buying bonds as described in an article from Bloomberg titled “The Most Powerful Buyers in Treasuries Are All Bailing at Once” which you can find at https://www.bloomberg.com/news/articles/2022-10-10/the-most-powerful-buyers-in-treasuries-are-all-bailing-at-once

An article from CNN Business is even more direct saying “The Bond Market is Crumbling” which you can find at:  https://www.cnn.com/2022/09/29/investing/premarket-trading-stocks/index.html

So, the bond market is the likely asset category that will blow first.  But there is also pressure coming on the stock market, which is clearly showing signs of stress from those rising interest rates. 

The interest rate to focus on is the rate for the 10 year Treasury bond.  And that rate is just about to cross 4%.  It is very likely when it solidly crosses over 4% that the market will react poorly and go down further – quite possibly 25% down year to date as measured by the S&P 500.  It is almost there already.  As of late in the afternoon on Thursday October 13, it is down 23% YTD.  

Stress in the Bond Market Will Put Stress on the Stock Market

Once the market moves solidly down 25% YTD it will dampen hopes for a big rebound like we had in June.  The June rebound made some sense because the 10 year bond interest rate was actually moving down when the rebound occurred, unlike today. Also, the continued downward movement of the market for almost 9 months is reducing enthusiasm for investors to buy stocks whenever they take a big dip. In the past, buying the dip worked pretty well.  This year, it has simply been a strategy for bigger losses.

When looking at the stock market (as well as the bond market) it is important to focus on buyers, not sellers.  It’s easy to imagine that a stock decline is caused by a lot of sellers.  But very often the problem is really a lack of buyers.  Many people simply hold through market downs.  But, if people become reluctant to keep buying stocks, prices can fall rapidly.  Even if only person is selling a stock, and there are no buyers, the price of the stock will drop to zero.

The next big problem the market is likely to face is a 4.5% yield on the 10 year bond.  This is the rate that could cause a panic in the market because it could push the S&P 500 down 30% for the year.  Although a 4.5% rate is not imminent in the next few weeks, it is very likely to occur by early November.  That’s because the Fed is likely to increase the overnight rate to 3.75% - 4% at their November 2 meeting. 

If the rate to borrow overnight is 4%, it would be hard for the 10 year rate to stay much under 4.5%.  

Of course, the rate could go to 4.5% earlier than the first week of November.  Either way, we are likely to hit 4.5% within the next 30 days. 

As mentioned in my article “Want to Know Where Stocks Are Headed?  Look at the Yield on the 10 Year Treasury Bond” an increase to 4.5% could create real anxiety among stock investors and move the market down 30% YTD.  If it does, that large of a loss may spook the market and cause a panic.

Plus, the bond market will likely be running into more problems and world stock markets will run into more problems as they deal with big declines in the value of foreign currencies relative to the dollar.  The pound and the dollar are almost at parity now. 

So, we have very nervous overseas markets which will rattle US markets as well.

The bottom line is that the bond market is most likely to fail first and cause the Fed to reverse its position and print more money. If not, the stock market is right behind the bond market in fragility with a move below a loss of 30% YTD likely to kick off some sort of rapid decline – enough to force the Fed to print money to prevent it from becoming a panic collapse.

The good news in all this is obvious.  A rapid collapse in either the bond or stock markets will force the Fed to print money to avoid a panic collapse.  And they may have to print a lot of money.  That will be sweet news for investors. As far as the bond and stock markets are concerned, the more printed money the better. 

The exact movements of the Fed and the markets are impossible to predict, but something along the lines mentioned above are quite likely.

What do we do about inflation long term?  Easy answer:  We solve it the same way we solved the problem of massive deficits and massive money printing – ignore it for as long as we possibly can.