The Federal Reserve has signaled that they’re going to be increasing the rates in 0.5% increments at the upcoming rate setting meetings. The market accordingly has priced in 0.5%, 0.5%, 0.5% for the next three meetings instead of ¼ ¼ ¼ as had been the previous guidance. 

Over the past two years, the biggest buyer of US Treasuries has been the federal reserve itself. In addition to the rate increase, the Fed is also pledging to reduce its balance sheet by $95B a month each month. Of that, $60B will be in US Treasuries and $35B will be in mortgage backed securities.

The reduction in mortgage backed securities will mean that banks will have fewer places to sell their loans to get them off their balance sheets. That might result in a lower liquidity mortgage market in addition to higher interest rates.

The US Federal debt is over 28.4 T in debt.  The vast majority of that printed in the past decade. That comes to $86,000 in debt for every man woman and child in the US. That comes to 137% of GDP.

US Treasuries are issued by the Department of the Treasury, under treasury secretary Janet Yellen, who used to be Fed Chair in the Obama administration.

So far at interest rates near zero, servicing that debt has not been a problem. But let’s imagine if interest rates were to increase to 6%. That’s not so far fetched when you consider that inflation has been running above 8%. If that were to happen, in a matter of a couple of years, nearly 50% of the US debt would reprice at a much higher interest rate. In fact 72% of US debt would reprice within 5 years. Let’s imagine that in a few years time, the cost of servicing the debt rises to 6% of the roughly 30T in debt. That means spending nearly 2T in just interest payments. Well the entire revenue for the US government was only just over 4T last year. They spent 6.82T. All of this was funded by the issuance of treasuries.

The biggest customer for those treasuries was the Fed itself.

Now if the Fed is going to shrink its balance sheet as publicly stated, they are going to be retiring debt from the Fed’s balance sheet. Not only is the Fed not going to be buying more of the US debt. But they are now net seller’s of debt into the market in direct competition with the Treasury to place those bonds. The Treasury is having to sell bonds their bonds at lower prices, which means higher yield in order to compete with this new competitor selling into the market.

If the stock market crashes, then it may change the dynamic. In the event of a stock market crash, we will get some amount of flight into the supposed safety of the bond market.

If the stock market crashes, then the Fed will worry about a recession. That would precipitate a reversal of policy at the Fed.

If the bond market crashes, causing rising rates across the board, then a stock market crash is inevitable. The Fed and other central banks will continue to raise rates, and we will see rising yields until we see a bond market crash, or a stock market crash.

Fed policy has played a major role in market liquidity over the past ten years and the past two years in particular. The financial markets are behaving like a drug addict, completely addicted to the next hit of crack cocaine. But like any addict, the hits need to be more and more potent to have an impact. If you remove the injections of cash, then the markets go through withdrawal.

We still have inflation. We still have high interest rates, and we still have economic contraction.

I defy anyone to make a case with confidence that 2022 will be a year of economic growth. We have continuing supply chain disruptions due to the pandemic. We have rising interest rates. We have runaway inflation. We have war induced global supply chain disruptions. 

For this reason I predict a stock market crash, recession, and a reversal of monetary policy.