More than a few people have been caught up in the rise in treasury yields portending inflation. Fortunately, the Federal Reserve aren’t so easily fooled, and prefer facts over misunderstanding.
It’s hard to overestimate how deep the confusion runs when it comes to understanding how bond markets work, but fortunately for us, it doesn’t quite run as deep as the Federal Reserve.
There are more than a few reasons to be concerned about the risks of an inflationary period following the massive stimulus that was delivered to our economy, first freezing it and then exposing it to as much heat as we could muster.
Once it thaws, things will be too hot for a more normal temperature economy. When it does, this means that the Fed will eventually have no choice but to turn the heat down, the dreaded reduction of the money supply that stock investors hate so passionately.
The 800 pound gorilla in the room isn’t the economy, or earnings, and while those wise to the game have always known that it is the Fed that plays the role of kingpin in this gang of concerns, and it’s not even close. Even in the face of a massive recession, depression-like even, and companies getting pounded by it, we have seen the bull market with stocks march on, not only unconcerned, but even emboldened. The Fed is the real gorilla in this story.
Meanwhile, the stock market hangs on every word of Fed Chairman Jay Powell, where even the prospect of his considering turning things down from wide open has scared them. Providing that the Fed continues to commit to this, they are kept happy, come hell or high water, but start to panic at the idea of the Fed starting to back off, and especially to take measures to try to cool things down.
This doesn’t really make sense from a practical view, even though it is true that expansionary money supply does put more money in the hands of people that can be used to invest in stocks and drive the price of them higher. There is an effect here, but it’s not that significant, and the vast majority of the effect that the Fed has on the stock market is just due to the market hitching its wagon to this as opposed to something else.
The Fed doesn’t put the value of stocks up or down by themselves, or at least not to a meaningful degree, but neither does things like economic growth or stagnation or even business growth or stagnation. The market merely sees these things and chooses to be influenced by them to whatever degree they choose. They choose to pay attention to monetary policy like nothing else.
When you instead take a mechanical view of stock prices, thinking that they are influenced by external factors and forget that stock prices arise instead out of a bidding process, where participants voluntarily choose how much or how little they are willing to pay for a stock rather than having this driven by other factors in a deterministic way, where stocks are alleged to have some sort of value apart from what the market decides, you can get pretty mixed up when your illusions get exposed by reality.
If people believed that the temperature outside was what truly drives prices, sure enough, we’d see prices rise in the summer and go down in the winter, because investors would bid them up in the spring and peak in the summer and pull money out of them as the weather gets colder. Beliefs aren’t just a major factor with stock prices, they are the only factor, and unless we understand this, there is no possibility of us understanding what really goes on.
The market simply decides what things are going to influence them, and while they do care about things like the economy and earnings, they don’t have to care at all, and non-believers sure got to see this in action in 2020. They do care deeply about changes in monetary policy though, and care so much that they sold off stocks after impressive earnings reports simply because they held an irrational belief that the Fed might be backing off their pedal to the metal stance even a bit.
This is never about whether these things make sense or not from an objective perspective, unless you think that stock prices are set objectively instead of realizing that this is a purely subjective process. This should not be hard at all to figure out, and all we have to do is look at the process itself to discover that the market decides on its own what it wants to pay, based upon whatever it decides to be influenced by, just like it does with Bitcoin. There are no illusions to dispel with Bitcoin though, but other than that, both cybercurrencies and stocks trade in the manner that the market decides, and purely so.
The market could choose to do the complete opposite of what they now do with changes in monetary policy, selling off during periods of expansion and buying during contraction, and that would be what we see. This process is not the market being pulled along by external factors, it is their choosing to be pulled by whatever they choose to be pulled by, and it turns out that they choose to be pulled by the Fed to an overwhelming degree, whether warranted or excessive.
It does seem way too much to expect the great majority of investors and those who provide guidance to them to not get this, as old illusions die hard, and these mistaken beliefs are so entrenched into investing culture that we aren’t even putting a scare into them after all these years. The misunderstanding about bond yields portending coming inflation, to an extent where we even throw out all the data we have on this, is an even more obvious error though that no one should be making.
If You Want to Predict Inflation, You Need to Look at Inflation, Not Bonds
No one studies inflationary trends like the Fed does, and no one even comes close. This is what the Fed does, it manages inflation, and they are the unquestionable experts on the topic. No one knows these things for certain, and we’re dealing with predictions here after all, but if you are looking for the most accurate predictions about inflation, you won’t find a better and more in-depth analysis than the Fed provides.
It is not that this isn’t subject to question though, and this is far from an exact science, as modeling never is. You make assumptions and project them forward, and the data you get out is only as good as your assumptions. It is not that we aren’t entitled to question the Fed’s projections when appropriate, and we did feel that their projections were understated prior to Biden and the Democrats taking over Washington, although the way that they plan on throttling back the economy has the Fed’s outlook now being more in line with what will probably happen, even though it still appears that the Fed is understating the coming economic revival at least somewhat.
The simplest way to explain the differences between administrations is to consider that the Trump administration put economic and job growth first, while the Biden administration pays a lot more attention to other goals which displaces this. When your concern about the economy becomes significantly replaced by other goals, this obviously will focus less attention on economic growth, and this is going to slow things down to the point where inflation is going to be less of a concern, in addition to whatever other effects such a policy shift entails.
However we may see inflation changing in the near future, we do want to be relying on data and evidence and not just choose a proxy of no merit such as how bond trading is going. If we insist on the same superficial understanding of inflation that we use to try to understand financial markets, as this can lead to some very ridiculous conclusions such as the bond market knowing something no one else knows, perhaps having some sort of magical crystal ball that only bond traders have, or even that bond trading tracks inflationary expectations in a mechanical way the way they think stocks track mechanical changes in economic factors.
They somehow don’t realize that bond trading is an auction process like stock trading is, and especially miss the part that the goal here isn’t to portray some sort of spread with interest rates but instead to try to make money trading these instruments. This perfectly describes the confusion with both stocks and bonds, where we treat these markets as if they were an efficient way to determine a desired spread between price and fundamentals, and the way they approach the bond market particularly exposes this misunderstanding.
There is no question whatsoever that inflation affects bond yields, as inflation affects the future value of income flows from bonds. As inflation rises, this reduces the value of bonds for those who hold them to capture this future income. These interest payments become diluted directly by inflation, but we know for certain that there is more to bond prices than this, otherwise we would see yields use inflation as a baseline like operating costs do with running a business, where the market is driven by participants recapturing their costs plus a market determined return on investment.
If bond investing were really about yields, about capturing the value of the income streams that they provide, we would always see yields higher than the rate of inflation, otherwise this would involve investing to lose money. If we get a yield of 1% and inflation is expected to be 2%, our investment would yield a net loss of 1% per year.’
It’s not that a lot of investors don’t make this mistake, but we at least know from this that it isn’t inflation spreads that are driving this, otherwise we would never see such a thing. We know there’s more to this than the inflation spread, and that other thing has to do with the other uses that bond trading involves, most notably the pursuit of capital appreciation.
There are two ways that you can make money trading bonds, and trading here means holding them for various amounts of time, from very briefly to holding to maturity. You can collect the interest payments, and you can speculate on the value of your bonds rising where you sell them for more than you paid.
If you just pay attention to the interest payments and ignore the changing value of bonds, this is going to leave you with a very incomplete understanding, especially given that most bond trading is of the price speculation variety. Bonds work like stocks, where you can make capital gains on them. This is the reason why most people trade stocks, and also the reason why most bonds are traded, even though this price speculation is mostly done by institutional investors and the public is generally unfocused on anyone doing this sort of thing.
What this means is that a large part of the movement of the price of bonds is not due to the expansion and contraction of inflation, even though this does play a role, it is instead from the forces of momentum that arise from speculation. Just like stocks go up when demand increases and go down when it wanes, the same thing happens with bonds.
This is why we saw treasuries rally so much in the period between the fall of 2019 and the summer of 2020, an epic move that took treasuries to such record levels. The public watched yields practically decrease to nothing, but the cause was how much more investors were willing to pay for treasuries.
Inflation was already very low, and it wasn’t the mechanism of inflation that drove this bull move or even had anything to do with it, it was instead a massive rush to buy U.S. treasuries, including the Fed jumping on once they opened things up so much after things got shut down last spring. This was not inflation driving this, it was a drive in the market toward the U.S. dollar as well as profit chasing, until we eventually reached a saturation point last August.
Along the way, the traders jumped in to ride the wave, and when bonds move, people jump on board to seek out the potential capital gains involved. None of this has anything to do with inflation, because these traders do not care where the asset might be years down the road, as they are not in it for the interest income, however devalued it may become later.
Should inflation rear its ugly face, this will affect demand for treasuries as well, one of several things that weigh in on demand for treasuries. It is ridiculous though to claim that movements in treasury prices serve as a predictor of inflation, a good predictor or even something that predicting inflation has anything to do with.
We have our indicators that show us where inflation is headed, the things that the Fed pays so close attention to, and this information plays in the bond market along with all other market influencers. When you see a change in bond prices without any accompanying change in the outlook for inflation, we can rest assured that the change was not produced by changes in the outlook for inflation, but by way of other factors, and completely so.
Knowing How Bonds Work for Fun and Profit
This is the rational view, and it should be pretty clear to those with even an inkling of understanding about this topic that this recent selloff in treasuries does not in any way suggest that bond traders are acting on some special knowledge about where inflation is headed that is otherwise unknown, as if they hear the voice of God telling them all about what is going to happen and act on the tip by selling more treasuries.
Bond traders do not have this sort of access though, and their concern is more for where bond prices are headed, where the herd is running to, and they have been slowly running away from bonds for a while now. The demand has waned, and the pressure on supply from those who wish to take their profits from the big runup or simply do not want to continue to hold their positions for any reason is what is driving this.
It wasn’t hard at all to call the top of this market last summer, because we got to the point where we shattered the all-time price records and the market really had nowhere else to go but down. This did not require much insight at all as we shared all of this with you back then, and while we would like to think that this call displayed great insight, it only took a little understanding of how these markets work, the things we are sharing with you here.
The institutional traders that trade these treasuries at 10 times leverage do have a much better idea of how bond markets work than the public and the peanut gallery financial media, and quite a few stock investors as well who actually get swayed by nonsense like thinking that profit taking in the treasury market forebodes higher inflation somehow. Jay Powell did help soothe nerves, but then the market got back to acting on this delusion again, selling their stocks because traders were selling more bonds.
If anything, money moving out of bonds is bullish for stocks, because at least some of this money is available to put in stocks instead, and there’s quite a bit of intermarket interplay between them.
Perception is reality with financial markets though, so it’s not that we can just pass this all off as nonsense and try to claim that the drop in our stocks isn’t based upon reality so our losses aren’t either. We have to follow the crowd as it runs in whatever direction suits them, mad or otherwise.
What we have learned from this is just how fragile this current bull market in stocks is, where the reasons for it to pull back continue to mount, and this current bull charging ahead the way it has with an attitude of damn the torpedoes does show that the market follows its own tune, but as the music becomes more discordant, their grip on the bull can become more tenuous.
We’ve been speaking of the appeal of short positions in treasuries since they peaked, and this might have been the easiest trade to call you’ll ever see, with prices so extended, the risk being low, and the upside being so high given how out of phase the market was with historical norms. It’s not that 2020 was in any sense a normal year, but the flight away from stocks only lasted a month or so out of the year, with the rest of the year having us pushing forward, which is what you want to see if you are bearish on bonds.
There is no real up or down with bond ETFs, as you can take positions long or short with the same ease, by buying long ETFs if you think the price will go up and want to seek to capture that, or inverse bond ETFs if you expect the price to go down and want to make money from that.
Those who want to can take short positions and just watch them rise in value as the treasury market continues to consolidate after being so overbought, and for those who like to drive faster, two times and even three times leverage inverse bond ETFs can add enough octane to these quieter investments that they can offer the same potential as stocks as long as treasuries are moving enough.
Taking a look at a popular 3X inverse treasury ETF like the Direxion Daily 20+ Treasury Bear 3X Shares gives us an idea of just how lucrative bonds can be. It is up a nice 40% so far this year, with the S&P 500 flat now and the Nasdaq down so far this year. There’s plenty more room to grow from here, especially given how recent downward selling momentum is turning off so many buyers and encouraging so many sellers.
It’s up more than this from last summer when we recommended this, when it was actually pretty clear that the downside from there on the short side was tantalizingly minimal with the upside being so promising. It has delivered some of this promise already, and as it proceeds along its journey toward removing all that extra buying pressure that the speculators drove it with, it is still worth a look even after it has delivered this much already.
You do have to be more aware when joining moves already well underway, but this particular move is stable enough to allow investors to jump on board without exposing themselves to too much risk provided that they manage these positions actively and bail if and when we see a reversal. There’s always the potential for a reversal, as investing can only seek to be on the right side of probabilities, but this requires the probabilities to be paid attention to as they change over time.
We also need to pay attention to this delusion with stocks in the face of their moving down based upon what is essentially a delusion. The market is always right because they get to decide everything independent of any other reality. We can still apply our knowledge of the reality of how this is supposed to work, as long as we do not use this to deny facts, to deny the beliefs that are taking us in a certain direction regardless of how mistaken they may be.
The real takeaway here is that bonds are more easily predictable than stocks, so when you get a clear opportunity to benefit from significant moves in either direction, we need to put aside all the misconceptions that we may have held about bonds for so long and see them for what they really are, and sometimes they can be a real opportunity.