What Will Interest Rates be When the Manipulation Ends?

• Interest rate manipulation requires massive money printing that is causing inflation
• In order to control inflation, bond manipulation must stop
• When the manipulation ends, bond prices will plummet, and stock prices will follow

The Federal Reserve has been manipulating interest rates since 2009, so 13 years. Most investors have become accustomed to losing to inflation in their bond investments that yield 1% when inflation is 2%, producing a “real” (inflation adjusted) 1% loss.

In theory, investors are not supposed to invest in assets with known real losses, but other central banks are also manipulating bond prices, so the usual alternatives are not viable. But the manipulation is causing inflation because it requires massive money printing to buoy up bond prices -- the Fed overpays in order to keep prices high and yields low.

So now attention is being redirected from price manipulation to fighting inflation.

A pretend fight. Think staged wrestling.

Cowboy wisdom advises “When you find yourself in a hole, you need to stop digging.” So it is with Quantitative Easing (QE) bond price manipulation and Zero Interest Rate Policy (ZIRP). The Fed is causing inflation, and it needs to stop.

Consequently, the Fed really isn’t coming to the rescue to control inflation. It’s actually backing off of the major cause for inflation, namely the printing of $13 trillion, which is more than our 10 most expensive wars combined.

The end of ZIRP brings an end to bubbles in stock and bond markets. Importantly, bond yields should return to their natural, unmanipulated, levels.

Unmanipulated bond yields

In normal, unmanipulated, situations investors price assets to be compensated for the risk with what is called a “risk premium.” History provides a clue to what these premiums should be, as shown in the following:

Bond yields should be inflation plus 3%, so 5% in a 2% inflation environment or 10% in the current 7% environment.

The impact of rising interest rates on bond prices

Bond durations currently average 6, so each 1% increase in bond yield drives down prices by 6 times that increase. A 4% increase to 5% causes a 24% loss in bond prices. A 9% increase to 10% causes a 54% loss.

The Fed will try to taper over a prolonged period of time, gradually reducing the manipulation, and it would not be a surprise if the Fed jumps back in as it did in 2018 if markets decline too rapidly but jumping back in will add fuel to the inflation fire. The Fed has painted itself into a corner.

Conclusion

The Fed needs and wants to appear to be in control, but it is not. Quite the contrary, unprecedented money printing is causing inflation that will accelerate if the Fed does not stop spending. It has announced that it will curtail spending (taper bond purchases) and increase interest rates. That part about increasing interest rates will happen naturally when the taper starts.

No one knows what the consequence of QE and massive money printing will ultimately be, but it can’t be pretty. Investors should not rely on Fed speak. Rather, they need to protect against imminent market crashes and runaway inflation. Yes, this is a warning article.

Recent stock market volatility, with markets swinging more than 2% up and down every day, reveals that investors -- both bulls and bears -- are on the brink of panic.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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