The Federal Reserve is dismissing any concerns about inflation, so do we trust them? Probably not.
Biden’s $1.9 Trillion Dollar Bet On Modern Economic Theory
The Federal Reserve is dismissing any concerns about inflation, so do we trust them? Probably not. Make no mistake, their so-called “full employment” agenda will cause inflation to rise and the economy to run hot. But despite the optics, their “theory” is already making the bond market very unhappy. The chart below shows the 7-year yield:
Compared to the summer lows of 2020, yields are up, but they are still below pre-pandemic levels. These rising yields might suggest the economy is recovering at first, but the government is actively fighting rising yields as it wants them to remain low to keep the economy “running hot” with their cheap money.
Are The Stock Market And Bond Market Correlated?
It’s critical to understand the “battle” between our government and the markets. From 1966 to 1997, the markets were primarily driven by inflation, and, generally, the stock market and the bond market moved in opposite directions (when one goes up, the other goes down and vice versa). That pattern changed around 1997 as inflation stopped being a significant factor, and the two markets have mostly moved in the same direction at the same time since then.
Should bonds and stocks move in opposite directions as inflation takes hold, the stock market will drop when interest rates go up.
How Does The Stock Market Perform Under Inflation?
Over the last 142 years, stock market investments yielded good returns only during times of disinflation. During inflationary periods, however, stock market investments did not perform well (see the blue line in the chart below).
During such inflationary times, the loss in purchasing power on stock market portfolios due to the erosion of the dollar was devastating to their holders—just imagine that the value of your investment stayed the same but incurred a 10% yearly inflation tax on its real value for a few years.
Compared to the summer lows of 2020, yields are up, but they are still below pre-pandemic levels. These rising yields might suggest the economy is recovering at first, but the government is actively fighting rising yields as it wants them to remain low to keep the economy “running hot” with their cheap money.
Will The Markets Lose Their Trust In Biden’s Theory?
One of the reasons markets have been going up and up is that they believe Biden’s narrative. They trust that the central bank will keep printing money and support the markets. But here lies the danger: Once the markets stop believing that the government can keep interest rates under control, things are going to get ugly for stocks real fast.
Biden can’t allow that to happen, of course. The central bank is purchasing $120 billion in bonds per month, but if rates keep rising, he’ll be forced to take action. The Democrats will try to control the yield either directly or indirectly, but this poses a problem — at some point, the continuous stimulus and money printing will welcome back full-blown inflation.
Add to that, if interest rates keep rising and result in a stock bear market (like we saw in 2000), the economy could enter a serious recession. This would increase unemployment again—the opposite of what the Fed wants. The reality is that Biden has no way to win this over time.
