Great Bond Market Expectations

The Fed has been procrastinating with raising interest rates in the hope that financial markets will price in the upcoming increases in the cost of money

Near-zero interest rates and lots of liquidity thanks to QE have been the tools with which the Fed worked to bring the economy out of the serious crisis of 2008. The present situation is, therefore, unprecedented as there have not been any similar situations in the past which would help one to foresee the consequences of raising rates in such an environment. This is now widely known and understood.

Nonetheless, the Fed believes that preparing the markets for the event is a good strategy. It is the case that stock markets sometimes anticipate developments, but there are other times when stock markets seem to have been oblivious to the disasters that in hindsight were fast approaching. The problem is rather that the practices of the central bank have produced effects that may have negative results. Equities have flourished since 2008, and bond managers seemed to be geniuses as their portfolios profited greatly from the booming prices of their holdings. This bond bull market has now come to an end.

As soon as the Fed starts raising interest rates, the bond market, which is huge, is going to react in the way that is specific to the bond market. When new issues have higher interest rates, bonds that have been previously issued and that are in the same class have to have the same yield, and that means that the price of the bond on the secondary market falls. That is a necessary consequence of the bond adjusting to the higher interest rate of new issues. The people in the Fed know this and so do bond managers along with investors.

The prices of equities will also suffer because bonds will then have an improved ROI without the drawback of the downside risk present in the stock market.

The rise in interest rates will make it more expensive for local governments and companies to raise money while pension funds will see their investments in stocks suffer losses after seven fat years.

If Joseph’s dream is applicable in this case, we can look forward to seven lean years. Commodity prices are down, there was practically no inflation following the huge injections of liquidity in the system thanks to QE, and low interest rates kept the economy going. It is always painful for addicts to undergo a cure that eliminates their drugs. The global economy is going to suffer great pain as the intoxicating drugs are slowly withdrawn in the hope of curing the patient of his addiction if he does not die.