What are the odds that the Fed is correct?
Below is a graph that I saw on an investment site I watch. It struck me that the current level of bond yields for the current level of inflation are so outside the norm and divergent from the mean that either the Federal Reserve is correct and the inflation we are seeing now is a temporary blip up OR we have investors betting on a big return based upon a low probability bet that could end very badly.
If you play the casino game craps, you know that it is all probability-based. You are betting that a number is or is not rolled before the number seven is rolled (seven being the number with the most combinations of the numbers on the dice – one and six, two and five, three and four, four and three, five and two, six and one – making it the highest probability of being rolled. The high probability bets are on the six and the eight since they have the second highest number of combinations. one less than seven. The odds are higher that you will win with a six and an eight, so your winnings are less when they hit. The big money is made betting on two, three, eleven and twelve as the combinations are limited so the odds that they are rolled before a seven are much smaller.
When I look at the chart above, the current plot point shown in red and labeled as such is so far from the mean (as represented by the red line) that its like betting on two or twelve, which are known as the sucker’s bets since the house’s odds of winning are so high that these are the numbers the house encourages you to bet on.
There is an economic concept called Yield Curve Control. Yield Curve Control is a process by which the Federal Reserve buys so many bonds with longer maturities that it keeps yields from rising – it’s simply our old friend supply and demand coming into play. The Fed provides more demand than the required supply so the treasury has no need to issue bonds at higher yields to fund the government. Since the 2008-2009 financial crisis, the Fed has been buying bonds as a way to increase the money supply and thereby stimulate the economy (we’ve written about this Quantitative Easing process on the blog in the past).
So what happens if the artificial demand from the Fed slows down? We can look back to 2013 because the Fed tried to do exactly that thing and it caused them a problem that has become known at the Taper Tantrum in the bond markets. The ten year treasury bond yield roughly double over a three month period in Spring 2013 when the Fed began to slow its purchases of bonds – ie., the demand dropped below the supply required to fund the government so the yield had to rise to entice people to buy the bonds. Before any major damage was done to the economy from the abrupt rise in yields, they resumed buying bonds at the previous level.
In recent statements from the Federal Reserve, certain members of its board have come out with statements saying that the Fed would need to start tapering in the future to ease up on the monetary stimulus that is helping to fuel the rise in inflation. This week, the Fed announced that they would begin to sell off the corporate bonds they purchased last year during the covid recession. Tapering seems to be real, even if it is beginning slowly with the sale of the small number of corporate bonds they own.
Going back to our craps analogy, in the world of economics and bond yields, it appears that the Federal Reserve is the house and they are encouraging you to buy bonds at low yields by saying that inflation is transitory. The big question is whether the bet to buy a ten-year treasury is betting on the six or betting on the twelve, and whether rolling a seven with inflation being higher for longer hits sooner rather than later.