Think Inflation’s Over?

Jim Rickards was correct.

Jim forecast that the Federal Reserve would sit upon its hands today — no rate hike.

And in fact the Federal Reserve sat upon its hands today — no rate hike.

Mr. Powell left his sword in its sheath.

The stock market reacted initially with a shrug of its slumping shoulders.

That is because it did not anticipate a rate increase. Thus its expectations were merely affirmed.

Stocks seeped higher following the announcement. They leapt higher upon further consideration.

The Dow Jones Industrial Average ended trading a jubilant 221 point to the good.

The S&P 500 gained 44 points and the Nasdaq Composite posted a 210-point advance.

Yet the fleeting fancies of the market, its momentary moods, its passing passions, hold little fascination for us.

They amuse us — to the verge of tears at times. Yet they do not fascinate us.

It is the grand sweep that fascinates us… the long view… the view of the circling eagle high overhead.

And the eagle’s gaze presently fixes upon the bond market…

The Flighty Birds vs. the Wise Owls

As we have noted previously… and to cling to our aviary theme:

The flighty birds of the moment congregate in the stock market.

Yet the owls — the wise owls — nest in the bond market.

The bond market will tell you where the economy is heading, they say.

It is not so easily foxed by the Federal Reserve’s garish and gaudy tricks. With knowing eyes it penetrates the magician’s secrets… and exposes the fraud upon the stage.

The bond market knows where the rabbit came from. It knows where the vanished gal is.

It observes the wires holding the levitating subject aloft.

New York Times economics reporter Neil Irwin:

Savvy economic analysts have always known the bond market is the place to look for a real sense of where the economy is going, or at least where the smart money thinks it is going.

What economic future does the smart money — the bond market — presently foresee?

It foresees a sort of transition point…

A transition point at which previously escalating interest rates begin to work their way through the economic machinery.

From 0 to 60 in 4 Seconds

Since last March the Federal Reserve’s target rate has leapt from 0.50% to 5.50%.

And since July 2020 the 10-year Treasury has skyshot from 0.53% to nearly 5%.

Thus the movement of decades compresses into years and very nearly months.

Mr. Jim Grant, editor of the eponymous Grant’s Interest Rate Observer:

The movement from interest rates bordering on nothing to interest rates knocking on the door of normal — that speed of rise — is something we have rarely, if ever, seen before. It’s like a car going from 0 to 60 mph in four seconds. So this is… a very disruptive rise because it has been so fast.

Thus we have an economy going largely on momentum. The 60-mph vehicle is on the chase. Yet has not yet run it down.

Yet history argues it will. Grant:

Going back about 150 years, there has been a succession of bond bull and bear markets, each one at least 20 years in length… bond yields fell from around the end of the Civil War for 35 years to the end of the 19th century.

Then, they rose very gradually for 20 years, whereupon they fell again from around 1921–1946. Next, the great postwar bond bear market began, taking yields all the way up to 15% in 1981. After that, the great bond bull market started that took yields down to 1% in 2021.

Again, the 10-year Treasury yield presently nears 5%

Mr. Grant notes the average cycle runs to 20 years. Yet the previous cycle commenced in 1981.

Forty years — twice the 20-year average!

Beware Reversion to the Mean

We operate from a theory. It is a theory we in fact cherish.

That is the theory that time — and/or the gods — iron out extremes.

The greater an elastic band is stretched, the more energetically it will snap back.

Scales balance even, that which goes up comes down, that which goes down comes up.

In brief: Time equalizes all.

And if the term “mean reversion” has anything in it — we believe it does — the bond market is in for a whale of a mean reversion.

Assume the 20-year cycle.

The bond market has amassed an additional 20 years of potential energy… awaiting translation into kinetic energy.

The transition commenced in 2021. Mr. Grant:

So perhaps since 2021 we have begun a lengthy excursion to the upside in yields — and if that’s the case, the catchphrase ought to be not “yields for longer,” but “yields for much, much, much longer”…

So it might just be that we are embarked on rates much, much, much higher for much, much, much longer. And it might just be that we are embarked on not just a cycle of inflation but an age of inflation.

“Yields for Much, Much, Much Longer”?

Yet are we prepared for this age of inflation, for this age of “yields for much, much, much longer”?

I suspect that this most sudden and even violent lurch higher in interest rates is going to test financial structures that came into being during the period of very low nominal interest rates.

Think of what all came into being, when money was proverbially free from 2010–2021… there were no constraints on sovereign debt issuance, so public credit was expanded dramatically. Interest expense seemed to be forever minimal and not worrisome because, after all, rates would never rise. To some degree, the entire world was capitalized on the expectation of extremely low interest rates…

Persistent, if not continuous declines in rates have been the norm for the careers and investment minds of most living human beings.

Consequently, expectations are deeply embedded in our collective psyche that rates do one thing, which is to decline. Yet here we are, observing them go up… So far, the stock market pretends not to notice.

We are not the least bit surprised the stock market pretends not to notice.

Recall, the stock market is where the flighty birds congregate. And that the wise oils nest in the bond market.

We hazard the latter will be munching popcorn at one point — and at the former’s expense. When?

We cannot precisely say. We cannot even imprecisely say.

“In the Making”

The economy presently goes on momentum as we argued above. We simply do not know when this reserve energy depletes.

Yet like Mr. Grant we believe it is “in the making”:

I think people are still trying to deal with the shock of the perception of the possibility of much higher rates for a long time. Not every company has had to refinance so far, not every private equity company has met a hostile reception in the credit markets and not every country has had to face the consequences of a potentially ruinously high national invoice for interest expense. All this is still in the making.

Things that are in the making come eventually out of the making.

They are made.

“The mills of the gods grind slowly,” said ancient Greek Sextus Empiricus…

“But they grind exceedingly fine.”

How fine they will grind in this particular instance… we do not know.

We pray the gods are kind…