Powell Got One Thing Right, “high interest rates … will bring pain”

Inflation, Rate Hikes and Bond Yields Correlation

Yesterday the BLS released the September CPI inflation report which showed that inflation increased by 0.4% in September. The report revealed that the CPI inflation index was at 8.2% in September year-over-year (YoY), a 0.1% decline from the prior month’s year-over-year of 8.3%. However, it was the core CPI that garnered the most attention. The core CPI in September increased from 6.3% YoY in August to 6.6% YoY in September.

Interest rate hikes have an intrinsic time lag to have any real impact on inflation and the core level of inflation is the preferred data that the Federal Reserve uses to shape its monetary policy. That being said, an uptick in the level of core inflation after the Federal Reserve aggressively raised interest rates from near zero to between 300 and 325 basis points over the last five consecutive FOMC meetings this year, which includes three consecutive rate hikes of 75 basis points each in June, July and September clearly show that the recent rate hikes are having a nominal effect on lowering inflation.

However, they have had a dramatic impact on the rising yields of debt instruments in the United States. The 10-year Treasury note yield broke above 4% today and after factoring in today’s 1.68% gain is currently yielding 4.02%. Yields on the thirty-year U.S. Bond are not far behind yielding 3.997%.

The Truth and Repercussions About Yesterday’s Core CPI Continuing to Worsen

The simple truth is that inflation is showing no signs of letting up, and this is causing angst as the expectations are growing in the financial markets that the Fed will raise their internal fed funds rate to 5% or higher by March of next year.

According to the CME’s FedWatch tool, there is a 96.7% probability that the Fed will implement another 75 basis point rate hike in November, and a 66.7% probability they will raise rates another 75 basis points in December which would take Fed funds rates to between 450 and 475 basis points by the end of 2022.

The repercussions of the recent series of extremely strong rate hikes will most certainly create extreme volatility and bonds, currencies, equities, and precious metals. The pace at which the Federal Reserve has been playing catch-up to the primary mistake of not raising rates in 2021.

Inflation in 2021 began at 1.4% in January and by December was at 7%, and the Federal Reserve did nothing to curtail inflation until March 2022. It is clear that had the Federal Reserve implemented small rate hikes in 2021 inflation would be nowhere near its current level. The Federal Reserve painted itself into a corner which forced their revision of the extremely aggressive rate hikes that we are currently experiencing.

According to the vast majority of economists, a fed funds rate of 5% or higher would have a devastating effect on the economy. It would be negative for stocks and earnings and lead to more selloffs in bonds. It could in essence shut down the ability for loans to be granted from individual loans such as mortgages or loans to corporations.

Even more worrisome is there are some economists expecting fed funds rates to rise to 6% at some point. The repercussions could easily exacerbate and accelerate a global recessionary scenario creating a major disruption in the global economy.

The sad truth is that this scenario could have been avoided had the Federal Reserve acted on rising inflation in 2021. While they certainly were not responsible for the black swan event that was a pandemic leading to a recession, they are completely responsible for not acting in an efficient and reasonable time when it was quite evident in 2021 that inflation was beginning to spiral out of control.

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Wishing you as always good trading,

Gary S. Wagner