Like the old Western movies, out of the desert come the vigilantes. Only this time, we are not talking about townspeople who have gotten together to chase the bad guys out of town. This time the vigilantes are the so-called “bond vigilantes”. The remerged in 2019, went silent, and are now back again.
The bond vigilantes are not an organized group. They are the bond brokers and bond traders who have been dubbed vigilantes because they follow the bond yield curve and when that curve inverts, they begin to forecast a recession ahead.
Paul Samuelson wrote the top selling economics textbook for college students, aptly named Economics, in which he pointed out that the stock market has correctly predicted nine of the past five recessions. Give that a little thought. I believe the same logic can be applied to the bond vigilantes: they overpredict recessions based on a metric that is only correlated to the cause, not indicative of it.
These most recent trends that they have identified are that short-term interest rates are at the same or higher level as longer-term interest rates. That is called an “inverted yield curve”. In a normal yield curve, interest rates rise as bond maturities get longer. The slope of the curve from left to right is upward. Longer maturities and higher rates compensate for the risk of inflation.
The bond vigilantes look at the invested yield curve and can claim several reasons it may be inverted and subsequently lead to a recession. The Federal Reserve is raising short-term interest rates and that often causes a slow-down in the economy. The Federal Reserve has $9 trillion of bonds on their balance sheet and must unwind and get rid of those bonds. The supply chains for many companies are unstable, if not broken, and that limits economic activity. The war between Russia and Ukraine has disrupted global oil supply. World GDP growth has slowed.
As I write this, I am flying from Seattle to Tampa for the National Association of Pension Advisors, and there has been a fair amount of turbulence during the flight. That reminds me of the logic of the bond vigilantes. The economy often experiences turbulence and perseveres. Remember: the market climbs a wall of worry. Like my plane, it occasionally experiences turbulence, but statistically that does not mean the plane is going down. The aircraft shakes and bounces and there may be passengers who are alarmed and worry that the plane may fall out of the sky. In recent years, there have been a number of notorious crashes, even.
But 99.99+ percent of flights arrive safely at their destination.
I believe we are going through some turbulence in the stock- and bond markets. Yet when we look at metrics such as job creation in the United States and worldwide, employment is approaching record levels. Company profits are reaching record levels. Cash levels are high. Banks are passing their stress tests. Capital spending on supply chain renovation is running high. Some 30-40% of workers are considering investing in remodel work on their homes to accommodate remote work. The Ukrainian war has accelerated the movement to alternative energy and the related investments.
There is reason to believe the inflation we are seeing worldwide is transitory. This inflation may be partially driven by shortages in the supply chain and to some extent by the stimulus packages which governments worldwide have employed to stay afloat during the pandemic. These factors are finite and may be coming to an end. The supply chains are getting revamped and remade. The Federal Reserve, which in effect printed $9 trillion during the Great Recession and the pandemic, will be taking that money out of the economy.
When you or I buy a bond, we must hold the money in our checking account or brokerage account to cover the purchase. When the buy is made our checking account or brokerage account is debited the amount of the buy and the seller’s account gets credited. But when the Fed buys, it simply credits the seller’s account. The Fed doesn’t have a checking account; it simply creates the money to buy. That is how the process works when the Fed “prints money”.
Today, the Fed has a record amount, some $9 trillion in bonds on its balance sheet, which it must reduce. They will either sell the bonds or let them mature and get paid the principal. In effect, the Fed will be “un-printing money”. They will be taking money out of the system.
When the Fed un-prints the money, it is deflationary and will have the tendency to push up longer-term interest rates. That in itself will work to correct the inversion of the yield curve. Yes, it will create more turbulence. But it should slow inflation if handled properly and gradually. As the Fed reduces inflation, bond yields will return to their historical rates.
As the Fed unwinds, it will benefit some companies more than others. It is important for investors to be poised with the right companies at the right time. It is likely as well to be a difficult time for bonds as rates increase and prices sink. There will be certain types of bonds that will benefit just as there will be companies whose stocks benefit. In our opinion, it will be a stock- and bond-picker’s market.
The bond vigilantes are out in force but in my opinion the inversion of the yield curve is more indicative of the Fed being slow to reduce their bond holdings rather than the prospect of a looming recession.
