If the Federal Reserve were hell-bent on quashing inflation, it would have raised their target range for federal funds by another 25 basis points at last Wednesday’s FOMC meeting.

They didn’t. Instead, they opted for “hawkish” sounding rhetoric about keeping rates higher for longer, maybe a lot longer.

Even with the economy going gangbusters, the labor market strong and set to get stronger as the UAW (United Auto Workers) leads the way to higher wages, benefits, and a shorter workweek, with oil prices approaching triple digits and gasoline prices rising nationwide -not to mention headline inflation close to twice the Fed’s 2% target – higher-for-longer, tough-sounding rhetoric replaced raising rates another quarter of one percent.

Why?

Because the Fed knows it can’t raise rates anymore, on account of things starting to break, but they still have to appear like steadfast firefighters trying to douse inflation.

What the Fed can’t admit, which scares the heck out of them, is that about $1.2 trillion of leveraged debt on commercial real estate in America is in deep trouble.

Banks that hold huge amounts of that debt and CMBS (Commercial Mortgage-Backed Securities) are facing liquidity and potentially solvency issues. Many of those same banks have been covering up holes in their balance sheets by buying deposits in the brokered deposits market and taking huge “advances” from their regional Federal Home Loan Banks.

Business bankruptcy filings rose 23.3% in the year ending June 20, 2023, and non-business bankruptcy filings rose 9.5%. The interest cost to taxpayers on the national debt was $352 billion in 2021; in 2022, it was $475 billion, and in 2023, it’s projected to be $640 billion. The Treasury has to issue more debt at higher rates to keep paying that interest and to fund every other government program.

The stock market is starting to stumble. In other words, things are starting to break.

Meanwhile, inflation isn’t coming down to anywhere near 2%, unless we fall into a very steep and deep recession. If we don’t – and lately the Fed has been predicting that won’t happen – we’ll see a “soft landing” where economic growth stalls or falters but catches itself as inflation abates and Goldilocks emerges as the face of the economy. Then, more growth will lead to more production and consumption, more credit expansion, higher wages, higher input costs, more inflation, and higher interest rates.

But not if stuff is starting to break, as I’ve been saying.

And since we’re on the verge of some serious cracks spreading, the Fed opted for “higher for longer” over another hike because “higher for longer” is just rhetoric.

Meanwhile, the bond market just “puked.” The yield on the 10-year Treasury hit 4.5% earlier today; that’s the highest it’s been since 2007. Now, with investors – bond investors, in particular – believing the Fed will keep rates higher for longer and possibly having “penciled in” another hike before the end of the year, why would anyone rush to buy bonds now when they might get better-yielding investments later?

So, investors will wait for higher yields. On top of that, speculators have been shorting bonds, driving prices down and yields up, betting they can cover their shorts by year-end at lower prices and then lock in higher yields as they “go long” on fixed-income assets.

That’s a great plan. Except for the fact that things are breaking.

If things get scary with any hard selling of bank stocks potentially leading to more bank runs, or any big defaults, or the stock market tanking, there’ll be a quick flight to quality – a rush of money into Treasuries. And it’s not just because they’re safe assets; now, you get great yields on Treasuries all across the yield curve.

A flight to quality in Treasuries would elevate bond prices and force shorts to cover, lifting prices even higher.

So, if you think stuff is starting to break and you want to ride a quick flight-to-safety bond market rally, buy some beaten-up Treasury bond ETFs like the iShares 20+ Year Treasury Bond ETF (TLT), or, on the cheap, buy some call option spreads and position yourself for a quick gain when the stuff hits the fan.

— Shah Gilani

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Source: Total Wealth