Lessons From Bond Market Turbulence

Treasury yields continued to gyrate over the past four days. Yield on 10-year securities fell sharply at the start of a holiday-shortened week as expectations switched to no increase in interest rates by the Federal Open Markets Committee on November 1. By Thursday, a hotter-than-expected Consumer Price Inflation report revived fears of an imminent rate hike and pushed up bond yields. This was followed Friday by a sharp decline in yields as some Fed officials suggested that the Federal Funds rate could continue where it is.

Behind the uncertainty causing the volatility is the reality that once inflation drops down to the 3 - 4% range, further mitigation will require gargantuan efforts. That is the lesson from the 1970s whose fiscal and monetary excesses found a match in a number of respects during 2020 - 2022 in terms of government spending, maintenance of near-zero interest rates, and doubling of the Federal Reserve balance sheet.

Even if monetary authorities remain focused on actually achieving their 2% inflation goal, the last mile will not be covered without a significant degree of pain — corporate losses, business failures, and rising unemployment. That is also a lesson we learn from history, this time, from the early 1980s.

Disappointment with the CPI report released on Thursday was partly due to the fact that core inflation — which the Fed prefers over the headline measure — persisted at a 0.3% month-on-month rate for the second successive month in September. It had accelerated from 0.16% in each of June and July. A second negative takeaway was that the source of overall inflation was shifting. While food and energy price increases — previously the major contributors to inflation — were stable or decelerating in September, inflation in shelter and non-energy related services accelerated, keeping core inflation elevated.

The yo-yo in yields last week was a result of investors being unsure if officials have the gumption to deal effectively with the inflation - economic growth tradeoff in an election year. With the stream of contradictory messages from senior Fed officials resuming, prospects for further monetary tightening — with implications for Treasury yields — waxed and waned from day to day even within the same market week.

Reducing volatility in Treasurys would go a long way in making the securities more attractive to global investors — a major advantage for the United States due to the seignorage benefit that it signifies. Increased stability would also lower yields and make it less expensive for the US Treasury to finance its ballooning deficit. Lastly, greater certainty in interest rates and bond yields will attract more capital to equity and property sectors, contributing to increased capital accumulation.

These were some of the objectives of Forward Guidance by the Federal Reserve that was championed by the then-Chairman Ben Bernanke a decade ago. Speaking in November 2013, he explained that “if monetary policymakers are expected [by investors] to keep short-term interest rates low, then current longer-term interest rates are likely to be low as well, all else being equal.” So investor expectations about monetary policy are crucial to having stable bond yields.

However, such guidance has not worked for the Powell Fed which is still fighting to regain credibility after grossly underestimating the intensity and duration of post-covid inflationary pressures. This is because the Chairman has not been able to stick to his word, transforming Forward Guidance into Forward Confusion.

Here is one instance. On June 15, 2022, Powell led the implementation of the first 75 basis point hike in rates since 1994. At his press conference that day, Powell said “clearly, today’s 75 basis-point increase is an unusually large one and I do not expect moves of this size to be common.” Yet, three more 75bp increases followed because — you guessed it — the Chairman and his colleagues had again misjudged the extent of underlying inflationary pressures.

How can the Fed improve on the situation? First, by speaking with one voice — preferably that of the Chairman — regarding where monetary policy is headed. Such a change in the communication process would replace the ongoing cacophony of discordant views by FOMC members, both voters and nonvoters, that adds to volatility in markets and contributes to higher bond yields.

Even the shift in the communication process may not help avoid recurring errors of judgment on the part of the Chairman and his colleagues. That is the reason for a second solution, already made in SriKonomics more than a year ago. Rather than shooting from the hip which characterizes the current interest rate setting process, conduct monetary policy using a rule that both policymakers and investors understand.

In a paper he wrote 30 years ago, Stanford University Professor John Taylor devised a rule that would provide transparency to market players and yet have the flexibility to vary with economic conditions. With increased certainty as to where interest rates are headed, markets can reduce the volatility that characterized last week.

What are the chances the Federal Reserve will implement such a rules-based policy, you ask. When was the last time a Washington, DC bureaucracy gave up its ability to do things at will?

Dr. Komal Sri-Kumar

President

Sri-Kumar Global Strategies, Inc.

Santa Monica, California

srikumar@srikumarglobal.com

@SriKGlobal

October 14, 2023

Sri-Kumar Global Strategies, Inc. advises multinational investors and sovereign wealth funds on global risk and opportunities.  Dr. Sri-Kumar is regularly featured on business TV and Radio media, and is a frequent speaker in global financial centers on major topics that affect markets and investments.

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