The Federal Reserve and other central banks have had a zero interest rate policy (ZIRP) since 2009, so investors have grown accustomed over the past 13 years to losing to inflation in their bond investments. which yield 1% when inflation is 2%. , producing a “real” (inflation-adjusted) loss of 1%.
In theory, investors are not supposed to invest in assets with known real losses, but since most central banks are also implementing ZIRP, the usual alternatives are not viable. But ZIRP causes inflation because it requires massive money printing to keep interest rates close to zero.
So now the focus is shifting from ZIRP to fighting inflation
The Fed must remain in control or at least appear to be in control
Cowboy wisdom advises “When you find yourself in a hole, you must stop digging.” It is therefore with Quantitative Easing (QE) that the ZIRP manages. The Fed is causing inflation, and it has to stop.
Therefore, the Fed is really not coming to the rescue to control inflation. It’s really about rolling back from the main cause of inflation, which is printing $13 trillion, more than our 10 most expensive wars combined.
The end of the ZIRP ends the bubbles in the stock and bond markets. Above all, bond yields should return to their natural levels.
Natural bond returns
In theory, and in a non-ZIRP world, investors set the price of assets to be compensated for risk with what is called a “risk premium”. History provides a clue as to what these bounties are, as shown in the following:
Bond yields should be inflation plus 3%, so 5% in a 2% inflation environment or 10% in the current 7% inflation environment.
The impact of rising interest rates on bond prices
Bond durations currently average 6 times, so every 1% increase in bond yield drives prices down by 6 times that increase. A 4% to 5% increase results in a 24% loss in bond prices. An increase of 9% to 10% results in a loss of 54%.
The Fed will try to pull back over an extended period, gradually easing the ZIRP, and it wouldn’t be surprising if the Fed backtracks like it did in 2018 if markets fall too quickly, but a pullback will fuel the inflation. Fire. The Fed has a real balance challenge: tap too fast and markets fall, too slow and inflation escalates.
No one knows what the consequences of QE and massive money printing will be, but it can’t be pretty. The recent volatility in stock markets, with markets swinging more than 2% every day, reveals that investors are traumatized.
In “risk on” or “risk off” jargon, it would be wise not to take any risk while the Fed does all it needs to do, to prepare for a better day when it does.