The Federal Reserve Stops Raising Interest Rates: Should We Buy Bonds and Stocks?

On November 1, 2023, Eastern time, the Federal Reserve held a FOMC meeting, and the market expected a second pause in interest rate hikes after September, keeping the current level of the federal funds rate unchanged at 5.25%-5.5%.

Stimulated by this news and Powell's press conference, U.S. stocks and U.S. bonds both rose on the same day. The Dow rose 0.67%, the Nasdaq rose 1.64%, and the S&P 500 rose 1.05%; The yield on the 2-year Treasury note fell 14.2 basis points to 4.954%, and the yield on the 10-year Treasury note fell 19.4 basis points to 4.739%.

Does the Fed's continuous stop raising interest rates mean that the current tightening cycle is coming to an end? When will the rate cut come? Will there be a new bull market in US asset prices? Is it a good opportunity to buy U.S. stocks and U.S. bonds?

This article analyzes asset price trends and U.S. household asset allocation from the perspective of the Fed's decision.

The logic of this article

1. The U.S. debt storm hits mediocre trading

Second, the household sector bought the bottom of the US Treasury bonds

3. Global allocation to hedge macro risks

[The text is 6500 words, the reading time is 15', thanks for sharing]

The U.S. debt storm hits mediocre trading

The Fed's aggressive tightening in March 2022 has set off round after round of U.S. debt storms. The US 10-year Treasury yield surged rapidly from 2% to 5%. In particular, in the second half of this year, the Fed was nearing the end of interest rate hikes, the dollar index returned to 107%, and U.S. stocks and U.S. bonds fell three times in August, September and October.

Heading into October, Treasury yields continued to soar, with the 2-year Treasury yield breaking through 5.2% intraday, the highest level since 2007. The surge in U.S. Treasury yields roiled global financial markets, with U.S., European and Asian equities falling across the board, with the Dow down 1.36%, the Nasdaq down 2.78% and the S&P 500 down 2.20%. It can be said that the U.S. debt has set off a "perfect storm".

Why are Treasury yields soaring?

The fundamental reason for this round of surge in U.S. Treasury yields is the Fed's aggressive interest rate hikes, but the main reason for the spike in U.S. Treasury yields in October is not monetary policy, not caused by the Fed's interest rate hikes, but the imbalance between supply and demand of U.S. bonds, specifically fiscal problems.

In the second half of the year, the bonds issued during the epidemic matured intensively, and at the same time, the implementation of the personal income tax reduction policy, the federal government had to issue large-scale bond financing, especially medium and long-term government bonds. In addition, at the end of September, the bipartisan game on the budget issue in the United States delayed the issuance of bonds, and the federal government began to issue bonds in October, triggering market concerns about U.S. bonds. In the second half of the year, the scale of treasury bond issuance was close to 1.9 trillion US dollars, of which the net increase of medium- and long-term bonds was 600 billion US dollars, and the net increase of short-term bonds was 200 billion US dollars, which greatly exceeded market expectations.

At a time when the Federal Reserve continues to raise interest rates and liquidity is tight, the federal government has issued large-scale bonds to raise funds, and the supply of bonds has expanded, and prices have naturally plummeted.

On October 12, the 30-year Treasury auction results were dismal, with primary dealers having to take over 18.2% of the Treasury bonds that were not bought by other bidders, well above this year's average of 10.72% and the highest percentage since February last year. The yield on the 30-year Treasury auction was also the highest since August 2007, nearly 50 basis points higher than the previous one. In addition, the auction results of $46 billion of 3-year Treasury bonds and $35 billion of 10-year Treasury bonds were also unsatisfactory.

On October 20, the U.S. Treasury Department disclosed data showing that the U.S. government budget deficit will widen to $1.7 trillion in 2023, an increase of $320 billion from 2022, a year-on-year growth rate of 23%. This equates to a further rise in the federal deficit ratio to 6.4 per cent. The Fed's continued interest rate hikes have pushed up the cost of interest payments, and interest expenses for the full year will reach $879 billion, more than double the $352 billion in 2021 and hit a record high.

In addition, after the Kazakh-Israeli conflict, Biden announced a $106 billion emergency funding application plan to provide aid to Israel and Ukraine. Geopolitical risks have increased the debt burden of the U.S. federal government to some extent, which has also exacerbated market concerns.

On the one hand, the supply of U.S. bonds has increased, and on the other hand, liquidity is tight and demand is sluggish, and several major buyers have reduced their holdings of U.S. bonds or expressed negative behavior towards increasing their holdings of U.S. bonds.

The Federal Reserve is the largest holder of U.S. Treasuries. At present, the Fed is still in a tightening cycle and continues to sell U.S. bonds as planned to recycle liquidity. The Fed has become the largest bearer of U.S. Treasuries in this tightening cycle, continuing to put pressure on the market.

Central banks and sovereign wealth funds in other countries are also among the bears of US Treasuries. Some emerging countries have reduced their holdings of U.S. Treasuries in consideration of geopolitical risks. This year, the size of US debt held by the People's Bank of China fell to $800 billion, a large decline from the peak.

Large financial institutions, mainly large hedge funds and investment banks, have been forced to join the ranks of short-selling due to large-scale losses. For a long time, U.S. Treasuries have been very reliable investments, the most important underlying assets held by large financial institutions for a long time. Financial institutions often hold Treasury bonds and pledge them for financing and reinvest them in other financial products. As an underlying asset, financial institutions generally do not sell US Treasuries easily. However, last year and this year, the price of US Treasuries fell sharply, exceeding the expectations of financial institutions. The underlying assets of U.S. bonds have shrunk sharply, impacting the balance sheets of financial institutions, raising debt ratios and increasing debt risks, triggering risk events for Silicon Valley Bank, UBS and UK pensions.

The devil's detail is also that many financial institutions enable leveraged trading. The Bank for International Settlements (BIS) pointed out in its September quarterly report that the leverage of 5-year Treasury futures is 70 times, and the 10-year is 50 times. For financial institutions that use leveraged trading on a large scale, the price of U.S. bonds has plummeted, and the risk has increased exponentially, and when the price falls to a certain extent, the financial institution has to add margin to deleverage. If there is not enough margin, financial institutions have to sell US bonds to redeem liquidity, thus exacerbating the decline in US bond prices.

Financial institutions, especially large investment banks and hedge funds that hold a large amount of U.S. bonds, are the biggest "black swan" in the current U.S. financial market. This round of sharp drop in the price of U.S. bonds has set off round after round of "U.S. bond storms" and slammed the "mediocre transactions" of international financial institutions.

After the 2008 financial crisis, the Federal Reserve implemented large-scale quantitative easing, and U.S. bonds and U.S. stocks set off a long-term bull market. This big bull market has fed a large number of "mediocre" financial institutions. These financial institutions do "mediocre trading", using customers' funds to invest in fixed income products, mainly U.S. bonds, and earn management from them. Since the price of U.S. bonds is very stable and is an ideal underlying asset, some financial institutions pledge U.S. bonds to obtain financing, and then invest in other financial products such as U.S. stocks. However, "this time is different", the Fed's aggressive interest rate hikes have caused US bonds to plummet, and the coupon of 20-year Treasury bonds in 2022 has fallen by 30%, the largest decline in history. This round of U.S. debt storms have hit these mediocre financial institutions and long-term inert mediocre transactions. This is also a wake-up call to institutional investors around the world that no asset is completely safe.

Even if the Fed stops raising interest rates, it will still keep interest rates high for a certain period of time, and market liquidity remains tight, so investors must pay close attention to the "black swan" in the reeds - large investment banks that may be broken down by the fall in US Treasury prices. Large investment banks are one of the few "black swans" that can trigger a liquidity crisis in financial markets.

However, US Treasury yields have soared sharply, and such high yields have attracted the attention of many investors. Many investors are considering whether they can buy the bottom of U.S. bonds. Who's buying U.S. bonds?

The household sector bottomed out on U.S. Treasuries

The Federal Reserve and public funds reduced their holdings of U.S. bonds, and the pension and household sectors increased their holdings, especially the household sector became the largest buyer of U.S. bonds. Although only 9% of the Treasury bonds are directly held by the household sector, 73% of the new Treasury bonds have been purchased by the household sector since the Fed raised interest rates last year.

A review of the transaction records shows that the household sector and the Fed appear to be rivals in the Treasury trade. While the Fed is tightening quantitatively and selling US bonds on a large scale, the household sector is buying on a large scale; While the Fed was easing and buying bonds on a large scale, the household sector was reducing its holdings of U.S. Treasuries.

The data shows that during the easing period from 2020 to 2021, the proportion of the Fed's net purchase of Treasury bonds reached 56%, and the proportion of net sales in the household sector reached 16%; During the 2022-2023 tightening period, the Fed will net sell 18% and the household sector will net buy 73%.

The two rounds of operation in the home sector are almost perfect. They reduced their holdings to $611 billion in 2021 when Treasury bonds rose, a reduction of more than $900 billion from 2019; Then in June 2023, it increased its holdings to $1.74 trillion when Treasuries continued to fall.

In this tightening cycle, the household sector is likely to outperform financial institutions in investing in U.S. bonds. The reason is that financial institutions are trapped by mediocre transactions, the strategy of holding U.S. bonds for a long time has been critically attacked, and the shrinkage of U.S. bond assets has constrained their investment ability, which may also induce debt risks. The household sector is much more flexible in investing in U.S. bonds, attacking and retreating, eating coupon interest when prices fall, and selling and cashing out when prices rise, and is less affected by the current round of U.S. bond storms.

At the same time, the balance sheet of American households is relatively healthy, American families have received large-scale financial subsidies during this round of epidemic, and at the same time, the interest rates of many mortgages, car loans, and consumer loans are locked in a lower range.

Inflation has continued to fall this year, Treasury yields have continued to rise, and real yields have also risen, which has encouraged the household sector to increase its holdings of Treasuries. The market expects inflation to continue to decline in the next two years, assuming that the average inflation rate is around 2.5%, and the real yield of buying 2-year Treasury bonds today can reach about 2.7%. If the price of government bonds rises in the next two years, it can also be sold for cash. For the household sector, this is a fixed income asset that can be attacked and defended.

Is it a good opportunity to buy U.S. bonds?

The key to judging the timing of buying US Treasuries is to determine whether the Fed has stopped raising interest rates and when to cut them.

The Fed's aggressive interest rate hike is the main reason for this round of U.S. bond plunge, and the sharp drop in U.S. bonds in October has become the main reason for the Fed to pause interest rate hikes in November; At the same time, it has lowered the expectation of another interest rate hike in the future, and also increased the expectation of a rate cut in the second half of next year. The Fed's pause button in November indicates that monetary policy considerations have shifted from inflation to recession, especially financial risks.

In the second half of the year, the headline inflation rate in the United States rebounded, but the core inflation rate, which the Fed is most concerned about, fell as expected, and the year-on-year growth rate of the core PCE price index fell to 3.7% in September, the lowest since May 2021.

The Fed is likely to be more concerned about recession risks than inflation risks. Although real GDP in the third quarter of this year was 4.9% quarter-on-quarter and 2.9% year-on-year, both exceeding market expectations, the US recession will accelerate from the fourth quarter to the first half of next year.

Affected by the impact of the epidemic and the Federal Reserve's policy, this round of US recession is a structural recession, with strong performance in employment and service industries, while the manufacturing, financial and real estate industries, which are sensitive to interest rates, have been hit harder. The US ISM manufacturing PMI for October released on November 1 ended a three-year winning streak and plummeted to 46.7, while the employment sub-item fell to 46.8 from the previous value of 51.2. This suggests that strikes in industries such as automobiles have had a significant impact on employment and manufacturing output.

Although the auto strike is nearing its end, as I had predicted, the auto strike punctures the monetary illusion and reminds employers of rising labor costs and reducing the number of employees to kick the door of a recession.

Based on the judgment of the trend of the U.S. economy and the consideration of U.S. bond risks, it is expected that the Fed will not raise interest rates in this tightening cycle, that is, in September this year. So, when will interest rates be cut?

Powell said at a press conference that it was too early to cut interest rates and was not within the scope of the Fed's current decision. It is expected that from September to June next year, the Fed will maintain the current level of the federal funds rate, and the Fed will start cutting interest rates in the second half of next year.

Usually, the Fed enters a cycle of interest rate cuts, and both U.S. bonds and U.S. stocks rise, establishing a new bull market. If the above judgment is correct, since the expectation is ahead, then now is a good time to buy the bottom of US bonds and US stocks. U.S. Treasury prices are at the bottom after this round of sharp declines, and yields on Treasuries are at historically high levels.

The so-called coexistence of risk and return, and the rise in US Treasury yields itself also indicates that US bond risks and economic risks are rising. How to identify the risk of U.S. bonds and economic risks is the key to judging whether you can buy U.S. bonds.

In the short term, there will be no solvency risk in US Treasuries, that is, there will be no default, but there will be liquidity risk, and the Fed's interest rate hike may trigger a "black swan" event, triggering liquidity risk.

Therefore, investors who plan to buy short-term U.S. bonds should be wary of possible liquidity risks in the future. Liquidity risk is more likely to occur in the coming year, from October 2023 to the third quarter of 2024, and 13-week and 26-week Treasury bills are more likely to encounter this risk. During this period, if a "black swan" event breaks out, U.S. bonds will fall sharply. This is extremely risky for investors who operate with leverage.

Investors who plan to buy long-term U.S. Treasuries should be wary of the risk of large inflation in the future. Typically, the longer the maturity of a Treasury bond, the higher the coupon rate. However, the longer the term, the greater the uncertainty. At present, one of the incoherent logic of US Treasury bonds is that the federal government has to use the method of monetizing the fiscal deficit to continue to roll over the debt, that is, the Fed cuts interest rates or buys bonds to avoid a default on US bonds. This means that the Fed is more likely to maintain its accommodative policy in the future than to tighten it, and a prolonged easing policy may trigger large inflation again. The biggest enemy of U.S. debt is inflation. In the event of a major inflation, it means that the real yield on US Treasuries may be negative.

Of course, no matter what maturity product you choose, you need to be flexible in your investment, control your leverage, and you can choose to hold the coupon when the U.S. bond falls, and you can sell it for cash when the U.S. bond rises.

It is expected that the Fed will enter a cycle of interest rate cuts in the second half of next year, and the price of US Treasury bonds will rise. It can be inferred that the risk of allocating medium-term treasury bonds is relatively small, and the yield is good.

Global allocation to hedge macro risks

In this round of U.S. debt turmoil, there is a very interesting phenomenon: on the debt side, households have made debt swaps, but the federal government has not; On the asset (U.S. bond) side, households have made asset allocation, while financial institutions have not.

As a result, household balance sheets have strengthened and the balance sheets of the federal government and financial institutions have deteriorated.

After the 2008 financial crisis, American households began to deleverage, and they seized two low-interest cycles to do debt swaps, locking in the interest rates of mortgages, car loans, and consumer loans at a low interest rate stage. According to the data, the debt-to-asset ratio of the U.S. residential sector fell from a peak of 19.1% in January 2008 to 11.1% in 2021.

As a result, in this aggressive interest rate hike cycle, although the Federal Reserve pushed the federal funds rate to a maximum of 5.5%, and the 30-year mortgage fixed rate even exceeded 8%, 90% of American households' mortgage rates are still locked below 5%, 30% of mortgage rates are locked within 3%, and many car loans are locked at half of the current interest rate. Interest expenses as a percentage of disposable income in U.S. households now rise to 2.7%, the highest since 2008, but still below the potential level of current interest rates. Of course, the federal government's interest-free policy on college student loans has also reduced interest expenses in the household sector.

However, the federal government, the largest debtor in the United States, failed to implement an effective debt swap. As the Federal Reserve continues to raise interest rates, so does the cost of interest payments for the Federal Treasury.

In the fiscal year ending September 30, 2023, U.S. debt interest payments totaled about $660 billion, up from $475 billion in the previous year. The Congressional Budget Office estimated on Oct. 10 that the federal budget deficit will be $1.7 trillion in fiscal year 2023 and $1.38 trillion in fiscal year 2022.

Wall Street investor Druckenmiller criticized Yellen for making a historic mistake, "I think it's the biggest mistake in the history of the Treasury if you go back to Alexander Hamilton." Druckenmiller noted that almost all Americans refinanced their mortgages when interest rates were close to zero. But the U.S. Treasury didn't do that, and Yellen didn't issue more long-term Treasuries before the Fed started raising interest rates early last year. This can be the trigger for a debt catastrophe.

In the second half of the year, the U.S. Treasury had to issue more long-term Treasuries to cope with short-term maturing debt, but the over-issuance of long-term Treasuries further hit Treasury prices. In the recent plan for the size of the Treasury bond auction, the Ministry of Finance had to deliberately reduce the size of the 30-year Treasury bond issuance to ease market pressure.

On the asset side (USD), households are more flexible in their transactions than financial institutions. Large financial institutions, affected by mediocre transactions, underestimated the extent of the decline in U.S. debt, resulting in a large shrinkage of underlying assets and an increase in debt ratios. The household sector makes a deal with the Fed, selling during the easing cycle, when Treasury prices are high, and buying bottoms during the tightening cycle and when Treasury prices fall.

After this round of easing-tightening, household balance sheets are stronger, and the pressure is on the US federal government and financial institutions that hold large amounts of US debt. Ordinary families in the United States have received big red envelopes, wages have risen rapidly, the prices of large financial assets have fallen, the federal government has been heavily indebted, and the gap between the rich and the poor in society has narrowed.

In fact, much of the resilience of the U.S. economy this year comes from relatively healthy household and corporate balance sheets. At the press conference, Powell said that the resilience of the U.S. economy, especially consumption exceeding expectations, may be the result of underestimating the strength of the private sector's balance sheet.

Economists need to reassess the Fed's monetary policy and the federal government's fiscal policy during the pandemic. What should governments and central banks do when a crisis occurs? What is the purpose? What is the best way to do this?

The government and central bank are a hedging market, and monetary and fiscal policy are a hedging product. In times of crisis, expansionary policies by governments and central banks aim to protect, improve, and strengthen households' balance sheets.

The Fed's unlimited bond purchases during the 2020 crash directly prevented the collapse of asset prices, preventing them from breaking down the balance sheets of governments, households, and businesses. Then, the sharp rise in stock and real estate prices sparked a wealth effect that further improved the balance sheets of American households.

In the past, Keynes advocated fiscal expansion, with direct government investment leading to a recovery in aggregate demand. However, many studies by economists have shown that government investment is rent-seeking, corrupt, inefficient, crowding out private investment, and widening the gap between rich and poor. During the pandemic, the federal government took an alternative approach, leaving finances at the disposal of the market.

The federal government has disbursed more than $2 trillion in financing directly to the household sector in cash, directly strengthening household balance sheets and indirectly improving corporate balance sheets. In addition to cash, the federal government has also cut taxes in the name of inflation this year, and the average effective tax rate for individuals in the United States from January to September was 12.1%, down 2.3 percentage points from the same period last year. Inflation in the United States has fallen this year, and wage growth has outperformed inflation, indicating that real incomes have increased. These are all reasons why household consumption remains strong despite the Federal Reserve's interest rate hikes this year. In short, the household sector has led to the expansion of aggregate demand by converting "extra" income into consumption.

According to my latest course, "Debt-Deflation-Interest Rate Cuts & Quantitative Eas", the Biden administration has directly replenished household balance sheets through cash distributions and tax cuts, avoiding the collapse of deposits in the banking system and the shrinking of the money supply under its multiplier effect. This shows that Bernanke's accelerator theory and Koo Chaoming's balance sheet recession theory are on the same path.

Keynes's logic is that the government borrows and government investment to drive aggregate demand, while the Biden administration's operation is that the government borrows debt to households, and households expand consumption and investment to drive aggregate demand, in other words, the Biden administration has given the task of expanding aggregate demand to the market and played the role of the market. This is the combination of Keynesianism and Friedmanism. Of course, I am not entirely in favor of Keynesian bailouts, and government and central bank actions are only effective in national markets.

Finally, the U.S. household sector has taken advantage of the Fed's monetary policy cycle to adjust asset allocation: on the one hand, it has increased leverage to buy houses during low-interest periods, completed debt swaps, locked lending rates in the low-interest range, and on the other hand, bought U.S. bonds when the Fed raises interest rates and U.S. bonds plummet. Due to the well-developed financial market in the United States, households hold a small percentage of their deposits, and they exchange their deposits for liquid financial capital. Today, the U.S. household sector owns 28 percent of real estate, 17 percent of stocks, 6 percent of mutual funds, and 17 percent of pensions.

In the last 4 years, American families have become the best traders in the world. Wages are up, houses are up, stocks are up, and at the same time holding high-yield bonds perfectly "harvest" the Federal Reserve, the federal government, and Wall Street capitalists. Just kidding: this is a victory for socialism, a crit blow to American financial capitalism.

American families have done this in this way, causing countless families in other countries to bend their waists. Times have changed, from one country to the world, from a single currency to multiple currencies, this is the era of global asset allocation.