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The bond market is telling us that inflation is coming, but the Federal Reserve keeps ignoring
Summary: The rapid rise in Treasury yields yesterday was most likely provoked by higher market inflation expectations. At this point, the Federal Reserve is making a huge mistake to ignore inflation threat. Increasing the bond purchasing program or engaging in yield curve control is going to reduce liquidity in the market, ultimately causing a liquidity squeeze.
Yesterday we saw the US yield curve steepening fast. The 30-year Treasury yields have risen by 14 basis points, which is the biggest move we have seen since the end of August. The market was quick to blame the move on Trump's better health conditions. However, we believe that at the bottom of the sharp rise in long-term Treasury yields, there are higher inflation expectations.
Inflation is expected to rise even faster now that Biden is leading the polls. A democratic win together with a fiscal stimulus package means that there will be higher money supply, putting more and more pressure on inflation.
The Federal Reserve is blind and the market will pay the consequences
We need to keep in mind that we are living in a Modern Monetary Theory (MMT) world where central banks have the last word to say. This week is full of speeches from various US federal reserve members. So far we can say that the one thing they agree on is that that the Fed bond-buying programme is there to stay. What they cannot agree on is whether it should be expanded or if there should be changes in the investment method. The President of the Federal Reserve Bank of St. Louis, James Bullard, today said that if the economic weakness continues, the FED would need to provide more stimulus. Yesterday, the President of the Federal Reserve Bank of Cleveland, said that she doesn't see the FED increasing the bond purchasing program. She would rather see the FED moving the focus towards longer-term bonds. Basically, what she is talking about is yield curve control, which can ultimately push the market into a liquidity squeeze as inflation rises.
Although MMT implies more money supply, in reality, it is killing the market with a gradual decrease in liquidity. As a matter of fact, what is happening right now is that the Fed is printing money to buy assets. Once these assets are in the Fed's balance sheet, it is like if they do not exist any longer: the Fed will hold them until maturity. Therefore asset prices are not high because of healthy market demand and supply; they are high because the Fed holds a big chunk them. This contributes to lower liquidity in the bond market because the Fed doesn't actively trade the assets it owns.
Eventually, we are running the risk that the FED will be too slow to hiking interest rates if inflation rises. Theoretically, volatility should be under control because of the Fed's large balance sheet. Still, in reality, if inflation rises suddenly and the Fed doesn’t hike interest rates, the burden of repricing will fall entirely on the bond market, making it even choppier than what it is now.