The trajectory of interest rate increases since March 2022 has been dramatic. The short-term Fed Funds Rate rose from zero to a midpoint of 5.375%.
Moreover, quantitative tightening to reduce the Fed’s swollen balance sheet has put upward pressure on interest rates further along the yield curve. Rates for deferred maturities have exploded higher. Thirty-year fixed-rate mortgages below 3% in late 2022 rose to over 7.5%, putting pressure on the housing market.
Meanwhile, the ascent of interest rates has caused problems for financial institutions, with several banks suffering substantial losses. Investing short-term deposits in longer-term debt securities resulted in significant mark-to-market losses.
Simultaneously, the turbulence in the geopolitical landscape with the bifurcation of the world’s nuclear powers and rising U.S. national debt levels have caused many holders of U.S. government debt securities to sell their holdings, putting additional pressure on the bond market sending rates higher.
The potential for a U.S. debt crisis has risen to the highest level in years.
U.S. long bond futures drop to the lowest level in over a decade and a half
- The U.S. 30-year treasury bond futures fell to 110-21 on October 3, the lowest level since October 2007.
- The long bond trend has been lower since the March 2020 high.
- Rising rates cause capital to flow from stocks and other assets to fixed-income products, weighing on retirement accounts.
- Rising rates exclude new home buyers who cannot afford the highest mortgage rates in decades.
Oil prices head higher
- Crude oil reached a bottom in May 2023, falling 52.1% from the March 2022 $130.50 high to $63.64 per barrel.
- Crude oil has been rallying since the May 2023 low, reaching a $95.03 high in September 2023.
- Crude oil is rising because of geopolitical tensions and U.S. and European energy policies addressing climate change.
Rising oil prices are inflationary
- Crude oil is the energy product that powers the world.
- The Fed measures inflation using core consumer and producer price index data that excludes volatile food and energy prices.
- Rising oil prices put upward pressure on all goods and services, pushing inflation higher.
Recession or worse on the horizon
- Rising interest rates slowly filter through the economy.
- The tidal wave of central bank liquidity and the tsunami of government stimulus in 2020 and 2021 planted the inflationary seeds.
- The Fed waited too long to tighten credit to address rising inflation.
- The lagged impact of rising rates could choke economic growth, causing a deep recession.
- Recession and high inflation create stagflation, a condition that is a challenge for the path of monetary policy.
The Fed may need to accept inflation to curb a crisis
- JP Morgan CEO Jamie Dimon said the Fed Funds Rate could rise to 7%.
- Fed Chairman Jerome Powell told markets to expect higher rates for longer.
- The U.S. central bank remains committed to a 2% inflation target.
- Foreign U.S. bond buyers are sellers.
- The downward trajectory of the U.S. government bond market and the rising potential for a gap even lower could trigger a debt crisis.
- The Fed may need to rethink its 2% inflation target in the current environment.