Back in 2011, a study found that the global bond market was nearly triple the size of global equities. To put that into perspective, McKinsey said there was $212 trillion in capital stock and bonds made up 75% of that number – and that was five years ago. I am quite sure it is even bigger today.
The enormous size of the bond market makes it attractive to investors looking for safety and income. However, the market is not a “safe” investing haven, because it’s ultra-sensitive to changes in interest rates. Rates increase when inflation rises and they decline or stay low when inflation is nascent, making inflation the only reason to shed bonds. Today, the market controls the long end of the inflation curve while the Fed has control of the short end via the Fed Funds Futures and short term rates. (The Federal Reserve is all too aware of the bond market machinations. In fact, the bond market has often done the Fed’s work in front of a policy change.)
Given the size of the bond market and the big impact inflation can have on it, there is enormous paranoia in bond investment land. A small tick up in inflation could result in several billion dollars in losses – and don’t forget that the US holds $8 billion in debt, where vulnerabilities are heavy.
I saw this paranoia first-hand in the early 2000’s when I worked with many bond traders at Countrywide Capital Markets. They were some of the smartest traders I have ever met, and they worked with some of the biggest funds around, but they were extremely paranoid. The joke was that they had predicted seven of the last two recessions.
Naturally, there is a diversion between what the bond market sees on the economic horizon and what the Fed would like to have happen. Today, bond yields continue to decline with money shifting out of equities and commodities. If we were to believe the bond market, there would be no rate hike in 2015 and a normalized curve may not be seen for three years or more.
However, take one look at the Fed Funds Futures, and you’ll see that there is a 24% chance of a 25bps hike in September and a 65% chance of a 10bps hike at the September meeting. December sees about an 80% chance of a 25bps hike, while January 2016 is fully priced. If the Fed raises rates, even in a slow cycle, then there should be implied inflation threats coming from the economy.
Again, the bond market is not seeing eye-to-eye with the Fed Funds Futures – and all the rhetoric won’t change the data. There is no mistaking that the Fed would like to move away from a zero interest rate policy (ZIRP). Chair Yellen and others on the committee have been quite vocal about their desire, but they must listen and respond to the bond market, otherwise the curve gets completely out of whack.
So far, the yield curve – while flattened out – is NOT showing that a recession is coming down the line. But the tail is wagging the dog here, and the risk of a recession is high if policy is changed at a time when the economy is not ready for it.
