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A Cautionary Note on Bond Markets




Bond markets are anticipating lower inflation and rate cuts here, encouraged by the Powell Fed. The extent of cuts has been dialed back from a consensus of 6-7 Fed cuts in 2024 at the beginning of the year, to around 3 now, but still expecting cuts. The markets may still be overly optimistic. Why? They did not read my notes from two years ago. We are in a new era.


On February 23, 2022, warned people the prior 40-year history of the treasury market was over and that we had moved back from a period of deflation to inflation:


“The forty-year tailwind of the Fed dropping rates from 20% to zero is now over. A few sanitary overly announced 25 basis point rate hikes will not magically make inflation to go away.  What the Happy Talkers don't seem to understand is that once inflationary psychology gets embedded as it is now, the Fed will have to act that much more aggressively later to solve the problem as Volcker had to.” [1]


Followed it up on March 10, 2022, with an outlier forecast that turned out to be spot on titled “30% Drop in the Long Bond?” Said:


“MEMO: Inflation is here. Could turn into stagflation.”

“It is a new era. The financial history of the past forty years is over. Change your thinking, financial models and algorithms to incorporate the new reality from deflation to inflation and maybe stagflation.”


“Hard to see how long duration assets do not drop a minimum of 30% from here over time with sporadic flights to quality due to war. That assumes the 30-year treasury bond yield only moves up a modest 1 3/4% from 2 1/4% to 4%. The peak in the 30-year treasury in the last inflation cycle was 15% in 1982 as a point of reference. [2] 


By October of 2022, 30-year treasury had indeed dropped 30%, and then by 45% by October of 2023. Today it is still down 37% from the March 2022 level.


The Fed belatedly tightened and now inflation is down, but it is above 3% vs. a target of 2%, economic growth is humming at 2.5%-3% and deficit spending a high 6% of GDP. This is not an economic backdrop demanding quick rate cuts.


The Fed has placed themselves in a bit of a bind. If they cut here, the bond market may take that as inflationary and push longer rates up more than currently expected, flattening the yield curve. If they do not cut, that may result in some disappointment as well. This makes forward guidance trickier. Another Fed induced dilemma. Just a note of caution.


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