In my last musing, I wrote about the current odd situation where the 30-year Treasury bonds yields 2.58%, but inflation is running at 8% annualized. Who would loan their money to the government for three decades while it is currently depreciating at a rate three times that? To add insult to injury, Treasury bond interest is fully taxable as ordinary income at up to a 40.8% tax rate. That’s a great deal…for Uncle Sam.

Treasury Bonds

I’m not saying that long-term bond rates need to suddenly leap to 8% for the math to work; buyers could have several reasons to hold coupons lower than the current inflation rate. For example, if rates were to fall to 1% a year from now, those 2.58% Treasury bonds would suddenly be worth 40% more money. But the current situation seems to reflect some hedging by investors who fear more turmoil in the world and the economy.

That low rate 2.58% long bond could easily get eclipsed by a 4% ten-year Treasury. Such an inversion of the yield curve is a defining note of an oncoming recession. Under normal conditions, shorter-term rates are lower than their longer-term counterparts because the risks are lower. This huddling in lower long-term rates is the hallmark of holders seeking longer-term cover from an impending storm while rising short-term financing rates indicates more acute stress issues required to be priced in at the near end of the curve. 

The Fed

At the same time, the Federal Reserve is somewhat backed into a corner, having remained sanguine about low interest rates while COVID clouds were gathering and then broke without response. While the Fed can control the Fed Funds Rate and Discount Rate, it has few mechanisms to control the longer 30-year part of the curve. The Fed has been active in quantitative easing (buying its own bonds to increase prices and suppress yields), but they are running out of money for that activity and may soon be sellers.

The government often finds itself set back on its heels because it favors academics over business experience in leadership, and the same leaders do not have a substantial personal stake in making good calls. Fortune favors the bold, but cronyism favors the defendable.

War and conflict aside, there are several domestic reasons for concern. Terrible energy policy has created roadblocks for domestic oil production at a time when we need it most. This has led to skyrocketing energy prices, exacerbated by the conflict in Ukraine. This trend was already a year underway, so don’t let the spin doctors convince you this is a Putin problem.

With rising energy prices, rising mortgage rates, rising Federal Funds rate, and soaring prices of agricultural goods and construction materials, the Fed will have ample opportunity to make some terrible calls and has already. Those handprints will be on the next recession.

Read More: Russian Surprises

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