The Bond Market Is Weird

The bond market is weird, but it’s full of clues. We have 8.6% inflation, but the highest interest rates have gone recently is about 3.4%, meaning real rates were still negative to the tune of 5%. This is confusing to me and a lot of other people.

If you look back at history, there were long periods with negative real interest rates and long periods with positive real interest rates. You might also notice that the periods with positive real interest rates were the good times and the periods with negative real interest rates were the bad times. We are currently in the bad times. We didn’t realize how good we had it.

Why are real interest rates still negative? Well, I have a couple of theories. One is that the bond market knows this inflation is mostly transitory and will quickly revert to the mean of around 3%–4%. The whole transitory thing is a running joke now—the Fed said inflation was transitory, and then it went up its nose, and it had to stop itself out of that view… but it really might be transitory.

Think about it: All the factors that led to this inflation—quantitative easing, money printing, fiscal spending, and pandemic hoarding—are all gone. As much as liquidity expanded in 2020–21, it is now running in reverse. The Fed is actually doing quantitative tightening, where it sucks money out of the money supply. We had the biggest expansion of liquidity and credit since WWII followed by what is now the biggest contraction. Small wonder the stock market isn’t down more.

In fact, if you created a one-factor model that attempted to predict the direction of the stock market using only liquidity as an input, it would be a pretty robust model. Never mind all the sentiment stuff about meme stocks and crypto—it’s all a function of liquidity.

The recent history is that bond yields gapped higher after the 8.6% CPI print a few weeks ago and are now edging lower. We saw the 6.28% print on 30-year fixed mortgage rates and panicked, but things are returning to normal. I expect yields to drop further in the near future. Whatever happens, though, my sense is that most investors are not paying enough attention to the bond market right now—we’re going to talk about this more in the coming weeks.