Of note: those losses are actually coming down as we speak.
With the Fed now expected by the bond market to pause rate hikes and start cutting rates soon, long term bond yields (as well as shorter term ones) have been coming down, increasing the value of those holdings.
You may have noticed this decline if you were shopping for CDs over the last few weeks. On brokerage platforms, top rates for 1 year CDs have gone down from a high of around 5.4% to 5% now.
Also of note: this decline only continues as long as the Fed actually cuts rates. If they don't, these long-term bond yields make no sense (why would you lend money for 10 years at 3.5% when you can lend money for 3650 successive 1-day terms at 4.75%?)
The logic behind this seems a bit circular to me. Market participants accept lower long-term bond rates because they expect the Fed to cut rates in the future. They expect the Fed to cut rates because if they don't, there will be a financial crisis. There will be a financial crisis because long-term bond rates are high and banks are underwater on their bonds, except that bond rates are declining because the Fed is going to cut rates, because...uh, why is there going to be a financial crisis again? What reason does the Fed have for dropping rates? It's very much an "appeal to consequences" fallacy - some bad outcome is not going to happen because that would be bad. The world doesn't work that way.
IMHO the market is wrong, and the Fed is not going to cut rates. They've gotten too accustomed to being bailed out, and the Fed is on to them, and so they're not going to do that again, at least not in the form that the market expects.
It makes more sense when you consider that the market has never believed long-term inflation was a serious issue because frankly the narrative around structurally higher inflation has never made much sense given demographics, technology and debt levels. For the most part where the uncertainty has existed has been in the path of the Fed.
For the last several months (since Jackson Hole) markets haven't been sure how quickly inflation would come down and therefore how high the Fed might risk taking rates. But today we have much more certainty. We now know the Fed really can't raise rates much more near-term given the risks and longer-term the stimulus and supply bottlenecks which created the majority of the inflationary pressures will ease.
Another thing you need to remember is that inflation easing is actually deflationary because real yields are calculated by nominal yields minus inflation. So as inflation comes down you're actually getting paid more to lock your cash up in bonds which continues to tighten financial conditions.
The risk of a larger financial crisis is very low given this isn't a credit event, but a duration event. As long as the Fed doesn't raise rates further we can rule out a financial crisis and so long as you don't believe there is a structural inflationary problem in the economy rates should trend downwards over the coming months.
Except that the narrative around demographics and technology has shifted to support higher inflation.
Inflation was kept low through the 2000s despite massive quantitative easing because you had the entry of 3 billion workers into the global economy, keeping wages low even though the money supply was high. That trend has reversed. China hit peak workforce employment in 2015 and their workforce is now shrinking fast, the result of their One Child Only policy in the 70s. The same demographic headwinds affect all major developed economies. Fertility rates fell below replacement rate in most of the developed world in the 1990s - that baby bust is now entering the workforce.
Similarly, technological progress has slowed down over the last 40 years. Much of the low-hanging fruit has already been picked; only a select few industries still show significant technological development. In particular, the major need-to-live industries like housing, health care, food, and energy have seen few yield-increasing technological developments over this period, and their price has risen accordingly.
> Except that the narrative around demographics and technology has shifted to support higher inflation.
We don't understand the drivers of inflation very well and people have different theories on this.
You may be correct though. Fundamentally inflation is driven by the change in the supply and demand for goods and services, and in a globalised world with rapidly changing geopolitical landscapes and technological advancements it's hard to predict actually how supply and demand pressures will balance out in the coming years.
However, what we do know is that demographics have historically correlated well with inflationary pressures. The inflation in the 70s was likely in part driven by the huge growth in demand which came from the baby boomers entering the economy. Then more recently you have examples like Japan where demographics have clearly played a role in their sluggish economic growth and low inflation.
But to be clear, I'm not saying the market is necessarily right in its pricing, I'm just suggesting that there's a lot of good reasons to believe the Fed funds rate is currently too high and will need to come down. Even if you're correct you would still have to explain why inflation rocketed up in 2021 right after trillions of dollars of stimulus entered the economy. The trends you're describing have been in place for years. The inflation we've seen over the last couple of years in my opinion is just far easier to explain via the combination of reckless monetary policy, fiscal stimulus and lockdown policies.
> (why would you lend money for 10 years at 3.5% when you can lend money for 3650 successive 1-day terms at 4.75%?)
That's the thing, you can't know that. Rates could go up, down, sideways, or in circles over the next 10 years. A 10-year bond locks it in to a predictable rate and payment schedule.
You can't, but the narrative presented for why rates will go down is that there will be a financial crisis that forces the Fed to drop rates. How can you simultaneously assume there will not be a financial crisis that wipes out a large number of financial institutions under those premises?
The world does work that way! Most people don't want bad stuff to happen, and will take action, coordinated or otherwise, to prevent bad stuff from happening.
To me, sounds like the Fed is trying to slow this thing down without spooking people. So, promise to cut rates soon, then see what people can actually tolerate, and maybe leave them high enough to chafe a bit.
Because rate won’t be 4.75% in 3649 days? If you want a rate guaranteed for 10 years you have to pay for that. Maybe it's not worth it to you today but if the rates drop as expected you might look smart for locking in a good return while the going was good.
What's the mechanism for that drop? The Fed doesn't just drop interest rates when everything is going well in the economy. The usual trigger is that some exogenous crisis happens like the Asian financial crisis, the global financial crisis, or COVID-19, and then the Fed drops to stimulate economic activity. Take a financial crisis out of the picture, because everyone who assumes there will be no financial crisis is explicitly taking a financial crisis out of the picture. Why would the Fed drop rates?
Only 55% of Americans own stock at all, only 35% in a non-retirement account [1], and the top 20% of earners own 87% of equities [2]. In polling, the stock market is not a significant factor in most Americans' vote. Stockholders tend to dramatically overestimate their numbers and importance.
Inflation, however, will reliably kill a presidency. Note that we went through 4 presidents in the 8 years of the 1970s inflation, while the average president in the 40 years afterward served for 8 years. This holds universally across cultures as well - globally, countries like Venezuela, Zimbabwe, Weimar Germany, post-war Eastern Europe, etc. go through rapid regime change during periods of high inflation.
Odds are there will be an economic downturn in the next ten years. Why? Because their usually is. It doesn't need to be a huge crisis. And that is when the Fed will drop rates.
Spot on. Listen to the language the Fed uses and this is the clear answer, recently they have been saying things like "we still have a lot of work to do on inflation", "the banking sector is resilient", etc.
This is the same FED who said "inflation is temporary" and then hiked rates like krazy.
I'm not saying this is proof that they won't hike rates, just that what they say should be heavily discounted.
They might just pivot on a dime.
What I find interesting is that literally everyone is saying that FED is wrong.
Like find me anyone outside FED that says: yeah, rising rates is good.
Granted, many people who comment (wall street) have self-interest in rates being low but I don't think there's any notable economist who isn't critical of FED.
FWIW I'm not suggesting that the Fed should or will continue to hike rates. I think they are going to pause rate hikes in the near term and wait for more data to ensure inflation does not become entrenched. The parent comment I replied to said "the Fed is not going to cut rates" which I agree with - but I also don't think they are going to hike rates either.
The Fed is projecting rate cuts next year. As of March 22nd, the Fed is projecting a federal funds rate of 4.3 in 2024 and 3.1 in 2025, with 2.5 in the “longer run”.
Hard to say the Fed won’t cut rates when their own projections have them cutting rates.
My point was more that the Fed wants to keep rates as low as possible. The person I was responding to was implying the Fed would choose not to lower rates even if they could to avoid “bailing out” the banks.
Why does the Fed want to keep rates as low as possible? Their mandates are to provide price stability and maximize employment, not keep rates as low as possible. Unemployment is very low so they are doing well in terms of maximizing employment, but inflation is still running hot, so the logical thing for them to do is keep rates high enough to stave off continued inflationary pressures.
The Fed wants to keep rates as low as possible because their mandate is to keep inflation at 2% and maximize employment. If inflation is at or under 2%, then lowering rates will increase economic activity and increased economic activity will reduce unemployment.
The unemployment rate is now 3.6%, about the lowest it's ever been. Where are these workers going to come from?
The Fed has been very explicit that they need to tighten labor market conditions. "Tighten labor market conditions" = "cause layoffs". That's how it works, they just can't say it out loud because it'll spook people. They can't bring down inflation until they raise rates high enough that companies start going under, and they have no incentive to lower rates unless actual bad things are happening in the real economy. (Remember also that when rates are high, the Fed has more room to cut when actual bad things do happen, because there's a floor at zero.)
I can't reply to your most recent comment rcme, but it sounds like you are agreeing with me? Yes, if inflation is at 2% then the Fed would be incentivized to reduce rates, but....it's not, it's over 5% and has been for some time.
Because there’s no guarantee rates will stay at 4.75% for 10 years. Getting 4.75% for 1 year and then 0% for the next 9 years is objectively far worse than getting 3.5% for 10 years.
What I have noticed is that CDs had lower yields than Treasury bills of the equivalent duration, until the bank runs happened. I think a lot of banks suddenly increased their CD rates just because they were also fearing a bank run. CDs lock in depositors' money a lot more. When the bank crisis subsided the CD rates went down because banks didn't feel a need to attract so many depositors.
Disclaimer: I bought a 5.4% CD a few days after the collapse of SVB.
I hope not. Interest rates need to rise. Yes, you're gonna make some people lose a lot of money. But the economy cannot continue with inflation this high and we certainly do not want to go back into pre-2022 craziness where money is thrown around at complete nonsense because it's so cheap.
I'm a big fan of the high-inflation economy, we should go back to that.
It seems to me that "inflation" is just another word for "worker power." It means there is low unemployment and lots of opportunities to hop to a higher paying job. It means you can work remotely and tell your boss to get stuffed if they want to RTO. Prices go up but if you play your cards right, you can increase your income by significantly more.
This is not true at all. The people most affected by high inflation are the lower-income people, who don't have flexibility. It's not always easy to just "find a new job". And salaries rarely are commensurate with inflation. Food inflation in the UK hit 18%, since when did low-income salaries go up that much? Spoiler alert: it doesn't and just leaves lower-income people in a deep hole.
It also means prices are higher. A significant portion of the population lives on fixed incomes or don't have the means to switch to a higher paying job, and were getting destroyed in the high inflationary environment.
The Fed has also agreed to buy the worthless bonds from banks, should they need cash, albeit they expect repayment @ 4-point-something %, which I understand banks immediately took advantage of. I guess we'll just deal with that problem later, as usual.
The bonds aren't worthless. The important distinction of the new short-term Fed lending program is that the Fed loans against the face value of the bonds, rather than the market value.
> Fed has also agreed to buy the worthless bonds from banks
Not worthless, worth less. The Fed has always let banks borrow against Treasuries at the discount window. The discount is to their fair market value. They created a new mechanism, the BTFP, which lets banks borrow against the face value of their Treasuries at a higher rate [1].
AFAIK, the Fed has agreed to lend banks cash on a short-term basis against their devalued (hardly worthless) bonds at par. If you have a source for the Fed agreeing to buy bonds I'd be very interested to read it, because AFAIK the Fed is selling close to $100B of bonds a month.
Also these are mark to market losses, and banks typically hold bonds to maturity. The only time this is a problem is if the bank is in need of liquidity and a) reserve ratios are pretty conservative post-2008, and b) the Fed is providing vehicles to support short-term liquidity issues (this reducing the need to sell assets and realize losses). As long as banks, their customers, and/or the media aren't freaking out the client base and encouraging a run, this is a non-issue.
With the Fed now expected by the bond market to pause rate hikes and start cutting rates soon, long term bond yields (as well as shorter term ones) have been coming down, increasing the value of those holdings.
You may have noticed this decline if you were shopping for CDs over the last few weeks. On brokerage platforms, top rates for 1 year CDs have gone down from a high of around 5.4% to 5% now.