On the Fed, Bonds and raising interest rates.
On the Fed, Bonds and raising interest rates.
When the Federal Reserve was giving its charter some one hundred years ago it was given a dual mandate to keep inflation low and the economy strong. A strong economy is considered to be a growing economy and since our monetary system is based on fractional reserve lending low interest rates are thought to promote a growing economy. However, since low interest rates create an abundance of money they cause inflation if the creation of money outpaces the growth of the economy.
Thus the Fed’s mandate is a balancing act. One of the reasons inflation is thought to be bad is that it leads to price instability, which is where it becomes difficult for businesses to make long term contracts because the future prices of goods and services is difficult to know. The other reason is that wages tend to be sticky and often lag behind price increases so that consumption decreases in an inflationary environment. These are both reasons why inflation works against the Fed’s mandate to keep the economy strong, however the main and hidden reason why the fed has a mandate against inflation is the Bond Market.
The Bond Market is not understood by the public, but it is very important, historically it has been a much larger market than the equities market, it may still be today. The US treasury market is about 40 trillion dollars for example.
The way bonds work is that you lend a fixed amount of money to an institution for a duration of time. Usually 100 or a thousand dollars and the institution pays you fixed monthly coupon. At the end of the bond term the institution will pay you your loan back.
So for instance if you bought a $1,000 5 year bond with at a rate of 5% you would receive 60 monthly coupon payments of $4.17 and at the end of the term you would get your $1,000 back. So at the end of five years you have made $250 profit.
Back to the fed and their inflation mandate. When inflation runs hot it undermines the bond market, devalues the current value of bonds and thus increases their yields. This sounds complex because of how financial language has been developed, but its actually really simple. Just apply the laws of supply and demand and the vague finance speak becomes clear, let me explain. The reason why people buy bonds is for the a rate of return, i.e. the profit they make off the bond. If inflation runs hot then the real ROI becomes less and the bond is therefore less valuable. If the bond is less valuable you pay less for it, if you pay less for it its price drops and because its coupon is fixed that means its yield as a percentage of the price you paid for it goes up.
So for instance lets say that inflation increases and makes a 5% $1,000 T-bill less attractive, the price of the T-bill may drop to $950 and the fixed coupon of $4.17 becomes a 5.26% yield. Rate changes also make bond yields either rise or fall. Just ask yourself would you pay the same price for a 5% $1,000 note compared to a 6% $1,000 note? Essentially the bonds fluctuate in price to match the going rate.
Why is this important. Well, bonds are important because treasury notes and bonds are how the US government finances its debt and they are first sold at auction to large financial institutions (insiders). If inflation runs too hot then the insiders can and will simply refuse to buy the bonds at auction and the government cannot fund itself. Secondly the bonds bought at auction are then sold to the rest of us through the secondary market. They are how rich people and institutions keep cash. Apple and Warren Buffet have billions of cash; they don’t keep it in checking or savings accounts; they have it in Treasury bonds and notes. That means that any increase in yields directly affects how much cash rich people, corporations, and institutions have. Also bonds are the reserves of banks, clearing and trading houses, essentially they are the liquidity and reserves of finance. So a change in bond yield affects the reserves and liquidity of the system and thus its solvency.
For instance if yields go down for a bank then that means they theoretically have greater reserves and they may make more loans, if yields go up then that means their reserves contract and they are at increased risk of insolvency. Thus from the mechanics of the banking side you can see how an increase in bond yields affect how many loans they can write.
Now you may be saying wait if the Fed increases the rate to keep yields down won’t that mean bonds with current fixed rates will be worth less compared to new issue bonds and thus their yields increase? The answer is yes, but how much? Does a 0.25% rate hike increase yields by 0.1% because the treasuries are mostly short duration and are held to redemption? Does it affect the long end of the yield curve or the short end? Does the decrease in inflation counteract the increase in yields? With these questions we have moved away from the mechanics of supply and demand and into the realm of speculation. Now I think we can make some pretty good guesses, but that’s beyond the scope of this article.
One thing that we can know about the debt market is that it has become huge. The US debt sits at over 40 Trillion dollars right now so any move in bond rates, even a small rate change is going to carry a lot of momentum.
How did we get such a huge debt? Well the short answer is socialism. The Federal government spent 7 trillion dollar last year, it only had 5 trillion dollars of revenue.
A lot of talk gets thrown around that the debt is manageable because its only like 1.2 times our GDP, which was 32 trillion in 2025, but here’s the thing GDP isn’t a real number. GDP is just the total amount of money that changes hands in a given year. For instance, borrowing counts towards the GDP, so that gap of two trillion dollars in the federal budget, that went to GDP.
Here's a real number: the average US worker makes $69,846.57 a year. There are 170 million workers in the US (only half the population works ~ Socialism) so the total gross pay of everyone that works was about 12 trillion dollars. That 40 trillion dollar debt looks a lot bigger now doesn’t it? Also we pay a crap load of taxes, 5 trillion dollars out of 12 trillion dollars is just the FEDERAL tax burden.
So the reason why yields have risen in the bond market is that the question has begun to be asked how can the US repay such a large debt?
Old adage about socialism is that it works great until you run out of other peoples money. The question that has begun to be asked is are we going to run out of other peoples money?
I really wanted to get into the nature of Gold and credit, but its getting late and I’ve run out of time so it will have to wait. Until then God bless and have a great week!
- Two points I want to add. One is that if you ever hear the term buyer and seller of last resort in regards to the FED or the treasury that means that nobody is buying bonds at the government auction so the FED or Treasury steps in to buy them by printing money, this is considered to be wildly inflationary.
- I forgot to cover that one of the dangers in rate changes and yield increases is that a lot of bond trading is done on leverage. Making 5% a year doesn't really cut it so a lot of these guys take out massive loans to buy bonds. The thing is that trading with leverage can make you a lot of money fast if the market moves the way you want, but it can wipe you out if it doesn't.