Message From the Bond Market

In its' statements accompanying Wednesday's announcement of an interest rate hike the Federal Reserve indicated confidence in the growth of the US economy and the prospect for further interest rate hikes to limit potential inflation risks.The recent sharp drops in the stock market seems to indicate skepticism as to those prospects.

Over in the bond market the signals are fairly clear: the market sees little prospect for inflation,risk of recessionary conditions and consequently a negative view towards Federal Reserve policy as leaning too heavily towards tight money/higher rates.

A few graphs will give a snapshot of the bond market's message.

The Federal Reserve has been on the path of reversing the10 year period of zirp or near zirp= zero interest rate policy/quantitative easing which began in response to the 2008 financial crisis.The ostensible rationale for such hikes is to slow economic growth and  prevent inflation, On Wednesday the Fed raised rates by .25% and indicated further rate increases in 2019:

But the message of the markets indicates little fear of inflation.

This can be seen most clearly in the 10year breakeven rate for TIPs Treasury Inflation Protected bonds. The rate subtracts the rate on tips from the rate on conventional bonds of the same maturity. If inflation exceeds that number TIP holders profit. Below is a chart of 10 year breakeven rates for 10 year bonds.

 

Another measure of inflation expectations is the rate on conventional Treasuries. Despite the Feds inflation fears the market of late has brought 10 year interest rates down from a recent peak just above 3.2%. This indicates a reduced fear of inflation. No one would purchase a 10 year Treasury bond yielding if they expected future inflation to exceed that rate and produce a negative real return the recent decline in ten year Treasury yields indicates lower inflation fears.

Another indicator of market sentiment is the spread between short term rates and long term rates. The Federal Reserve can control the overnight Fed Funds rate but not longer term rates. The "spread" (differential) between short term and long term rates indicates the markets assessment of the extent to which Federal reserve tightening is sufficient or excessive.The current gap between Fed funds rates and ten year Treasury bonds is at the extremely low level of. The is indicates the market my feel the Fed has "gotten ahead of itself" with short term rates quite high relative to the market expectation of future inflation reflected in longer term interest rates.

Finally, there is the risk of recession, A widening of spreads between Treasury bonds and investment grade corporate bonds and between high yield (junk) bonds and investment grade Treasuries indicated increased fear of recession and defaults on credit bonds.

Inflation grade bonds vs Treasuries

High Yield Spreads:

It remains to be seen who is correct in their assessment of economic conditions, But it is clear at present there is a disconnect between the views of the bond market and the Federal Reserve.