Cracks in Bond Markets Won’t Scare Off the Fed – Here’s What to Do

Shah Gilani|October 6, 2022

The almost 6% rally U.S. stock markets enjoyed Monday and Tuesday this week was based on the belief that the Fed would soon have to “pivot,” stop raising rates and start lowering them.

Pivot talk worked its magic on stocks this time because investors believed the Fed could not ignore scary cracks in global bond markets as harbingers of what could happen to financial systems if they keep raising rates.

Investors saw those serious cracks and figured every central bank in the world saw them too. And given that if those cracks widen enough, whole financial systems could fall into them, it would naturally follow that the Fed and other central banks would have to pivot.

At least, that was the prevailing narrative pushing stocks higher earlier this week.

But it’s all just wishful thinking. What happened in the U.S. and in the U.K. recently were indeed indicative of serious cracks in bond markets, but they were contained, and central banks went right back to their hawkish rhetoric about raising rates to tamp down unacceptably high inflation.

Because the mainstream media isn’t covering this to any great degree, I’m going to do it for them.

Let me explain what was so scary, how it was contained, and what it’s telling us about global bond markets. I’ll also go over why the Fed will keep raising rates and keep them higher for longer, what that will do to stocks, and how to make money on falling equities and know when the real pivot’s going to happen.

Fault Lines in the Global Bond Market

The first crack, which happened in the U.S. mortgage-backed securities (MBS) market in September, wasn’t widely seen or heard, but enough institutional investors and smart operators understood it for what it was – a crack in one of the country’s biggest markets.

This story goes back to the end of May when the Fed announced it would start quantitative tightening, or QT, in June, by letting $17.5 billion of MBS and $30 billion of treasuries runoff its balance sheet every month. Runoff means maturing bonds within the Fed’s balance sheet wouldn’t be replaced. In other words, the Fed wouldn’t be in the market buying bonds to maintain its $9 trillion balance sheet.

The May announcement declared that starting in September, the allowable runoff in MBS would be upped to $30 billion a month and to $60 billion a month in treasuries.

But in September, instead of letting mortgage-backed securities runoff the balance sheet, the Fed bought them instead, contradicting their announcement.

That mini pivot was necessary to arrest fast falling prices of mortgage securities, which were dragging down fixed income and bond portfolios around the country.

The hits were a matter of “duration.”

If you own any MBS or a portfolio of MBS, or are Freddie Mac or Fannie Mae, you know what duration is. It’s the average maturity of your MBS holdings.

When interest rates come down, mortgage holders refinance, meaning they borrow at a lower interest rate and pay off their higher cost mortgages. If you own MBS and higher interest 30-year mortgages within your securities package are paid off, the duration or average maturity of your remaining mortgages will almost always be less or shorter.

The opposite happens when rates rise. There’s no incentive for mortgage holders to refinance at higher rates, and because rates are rising, the actuarial calculations that determine average duration or maturity of a securities package increases the average maturity of the remaining MBS.

Now, when rates rise more, longer maturity bonds (and MBS duration is getting even longer) get hit harder.

That’s a double whammy for MBS holders, leading to what happened in September.

The Fed stepping in to buy MBS and support falling prices was a sign of a serious crack. If they had let billions of dollars’ worth of MBS runoff their balance sheet, those securities would have to be bought by other investors. But those investors weren’t about to buy more MBS, as their duration was lengthening and their prices were falling. The Fed had to intervene to keep the market from bottoming out.

Then last week, the Bank of England had to step in and buy 30-year gilts (gilts, as in gilt edged, are what the British call their treasury bonds) to plaster over a scary crack in the country’s pension systems, or “schemes” as the Brits call their pension plans.

The short story here is that in a low yielding environment, which lasted for more than 15 years, pension plans amped up their returns by trading derivatives in particular swaps. Using the 30-year maturity gilts they held in their portfolios as collateral, pension managers and trustees bought long dated fixed rate bonds and essentially shorted adjustable-rate notes as part of their interest rate swaps.

When rates on shorter maturity notes adjusted higher, pensions got margin calls or were closed out of their positions, and then had the collateral they posted, 30-year gilts, sold out. That selling of collateral tanked 30-year gilt prices.

That’s why the BoE announced in the midst of QT that they’d be buying 30-year gilts and only 30-year gilts.

That selloff was indicative of a serious crack in the UK’s bond market and pension schemes.

Unfortunately, however, even though these evident cracks are probably the tip of the iceberg of monumentally leveraged securities, bonds, positions and institutions that could turn into the next LTCM (Long Term Capital Management, the currency and credit hedge fund that famously blew up in 1998 and almost took down several money center banks), the Fed is hellbent on proving its credibility and sticking with higher rates for longer to tame inflation.

This is going to send stocks lower as real-world implications work their way through earnings and necessitate re-rating and re-pricing securities in every portfolio out there.

The way to make money on falling stocks is by targeting stocks that you know are going to fall because rising rates will cost them exponentially more to refinance their mounting debts. If they don’t make any profits and have to keep rolling over their bigger and bigger piles of debts, eventually they’ll collapse.

That’s what we’re doing in my subscriber service, and we’re raking in huge gains, by the way. I suggest you do the same.

Meantime, I’ve no doubt the Fed will raise rates too high and keep them there too long and more than a few cracks will widen into multiple financial crises.

That’s when there’ll be a pivot. I’ll let you know exactly what to do when that happens.