Bonds yields awaken, Fed is feeding inflation, needs 4-5% Fed funds rate

The increase in US bond yields is most likely appropriate and may well continue.

A key under-pinning of the recent very strong rally in equity markets, up 9% since the last Fed rate hike, has been the idea that bond yields are headed lower and the Federal Reserve is almost finished?

The latest Federal Reserve minutes confirm our view that there is still a long way to go in fed hikes. Even as high as 4.5% to 5.5%.

What the Bond market may have under-appreciated, is that the Fed Funds Rate is currently highly stimulatory. In other words, the Fed is actually still feeding inflation.

There is zero prospect of the Federal Reserve pausing until it reaches some new neutral. This is likely somewhere in the 3.75% to 4.5% range.

The most comfortable Fed rate level over the long term appears to have been 5%.

While one of the first economists to previously highlight the new normal was much lower in the age of globalisation, Covid instantly removed the globally competitive price environment and reverted the global economy to a place of profit margin fattening. Companies were able, and are still able, to raise prices without losing market share. This is a game changer. For corporate earnings, but also for the challenges of containing runaway inflation.

Inflation is very firmly in place in the US economy now.

Any resumption of upward energy price movements will immediately see US inflation back above 9% again. Many months ago, I forecast we could see 10%, even 12% in the US. The UK just hit 10.1% yesterday.

Bond markets are reacting to this on the day, but may recover momentarily. The more telling development would be for the market to recognise/join our forecast, that the Fed still has a long way to go to just remove generating the current inflation rate settings. It wants to be stopping inflation in its tracks. That just will not be happening below 3.75% at least. The fight against inflation is likely to only become truly effective in the 4.0% to 5.5% range.

Should bond markets come to this view, it would be a sudden warning alarm to equity markets. Which, after recent impressive strength, are already highly vulnerable to just a technical correction.

Let alone, recognition of a deteriorating economic and more aggressive Federal Reserve outlook both.

The double whammy stock killer of a weakening economy and even higher Fed rates, look set to continue through the rest of this year and into next.