Losing the Bond Market

The highway's jammed with broken heroes
On a last chance power drive
Everybody's out on the run tonight
But there's no place left to hide
--Bruce Springsteen

Fleck laid out a roadmap last night for how the Fed might lose control of the bond market. In his view, this is how market forces will regain control of the system. When the bond market no longer stays stuck at artificially low yields manipulated by the Fed, then the game is over.

He proposes that losing the bond market will not happen overnight. Rather, it will occur in stages over time. We are in the first stage now. The Fed has started to reduce (i.e., 'taper') its bond purchases. Ten year yields have jumped from all time lows of 1.6% to today's 2.8%. Why? Without Fed support, bond prices will likely be lower. Some traders understand this and are already headed for the exits.

But yields are still low by historical measures, which has muted the reaction by market participants thus far. However small the nominal change, though, the fact that rates are higher at a time when the Fed does not want them higher signals that the Fed is beginning to lose its grip on things. 

Fleck also suggests that, although we are early in the process, it is not out of the question that early tapers will put a lid on further stock advances, and may even drive a significant price declines. Essentially, tapered bond purchases parallel early Fed interest rate tightening in past cycles (e.g., early 2000) that reduced liquidity and caused leveraged sentiment to turn negative ahead of other, more visible influences.

The next stage will be when the Fed stops tapering in response to stock market and economic weakness. Although stocks and bonds are likely to rally initially on the Fed's action, Fleck suggests that it will dawn on more people that the Fed is trapped and can't stop printing money if it does not want the price of financial securities to fall. Many investors will connect the dots and realize the implications for prices of goods and services (higher). When this is perceived, then bonds will tank.

The final stage is when markets fear the roll out of any additional easy money policies out of concern for inflationary consequences. This is the exact opposite where we are today--markets generally welcome any and all spectres of easy money.

When the bond market revolts to, rather than cheers, the Fed's easy money ways, then the printing press is effectively taken away.

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