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BEAR MARKET WATCH  •  October 2, 2023  •  Jon Wolfenbarger

What The 50% Collapse In Bond Prices Means For The Stock Market

BRAGA, PORTUGAL — One of the biggest and most pervasive myths on Wall Street is the myth of Fed omnipotence. 

Investors — amateurs and professionals alike — seem to believe that by using their various “tools” to create money out of thin air, the Federal Reserve can control the economy and financial markets any way they like. They believe the Fed doesn’t want a recession, so they can prevent one. They also believe the Fed doesn’t want a stock bear market, so they can prevent that too.

The Market Is Much Bigger Than The Fed

But the world doesn’t work that way. The economy and financial markets are much bigger and more powerful than the Fed. The reason the Fed appears to “work” in preventing recessions and bear markets is because recessions and bear markets are typically much shorter than economic expansions and bull markets. It’s as simple as that. The market is ultimately in control and the Fed just goes along for the ride.

Let’s compare the size of the Fed to the economy and financial markets to gain some perspective. The Fed’s total assets are $8 trillion. That is very big relative to my assets (yes, being able to create money out of thin air is very helpful in accumulating assets!), but it is still much smaller than the economy and stock and bond markets. US GDP is three times bigger and global GDP is 12.5 times bigger. The US stock market is nearly six times bigger and the global stock market is nearly 14 times bigger. The US bond market is six times bigger and the global stock market is 16 times bigger.

The Fed Has Been A Massive Failure

As we discussed here, the Fed was supposedly given three main goals by Congress: 1) maintain a stable price level, 2) maintain full employment and 3) maintain low interest rates.

If the Fed was really in control, we would always have something like 2% inflation (and why 2%? why not 0%? or negative 2%? or some other number?), 4% unemployment and 0.5% interest rates. The low interest rates are particularly important for the government, since they have so much debt.

But we obviously don’t always live in such an “ideal” world.

If the Fed was really in control, how did they allow the Great Depression of the 1930s to happen? Or the “stagflation” of the 1970s with double-digit inflation and interest rates? Or the Great Recession of 2008-2009? Or the high “transitory” (never-ending?) inflation we’ve had the past couple of years?

Perhaps most importantly for the Fed’s real constituents — the Federal government and the banks — how did the Fed allow interest rates on 10-Year Treasury bonds to skyrocket from 0.52% in 2020 to 4.59% now? How did the Fed allow Treasury bond prices to collapse 50% in three years? How did the Fed allow Federal interest expense to more than double to over $1 trillion in three years? How did the Fed allow the Federal interest expense to Federal tax receipts ratio to double to 15% over the past two years, as shown below?

How did the Fed allow the KBW Bank Index, Bank of America and Citigroup stocks to fall over 40% the past two years? 

How did the Fed allow banks to lose over $500 billion on their investment securities in the past couple of years?

Source: Hussman Strategic Advisors

How did the Fed allow itself to generate a negative net worth of $2.4 trillion?

Source: Hussman Strategic Advisors

Maybe the Fed really cares about the American people. Maybe they feel really bad about causing the Great Depression, Great Recession, high unemployment, high inflation, etc. Or maybe they don’t care that much. Who knows what goes on in the minds of government central planning bureaucrats?

But it is clear that the Fed did not want to lose so much money for the government, banks and itself. If this doesn’t dispel the myth of Fed omnipotence in the minds of investors, we don’t know what will.

What The Bond Market Collapse Means For The Stock Market

The first important point about the 50% collapse in government bond prices is that since the Fed couldn’t prevent that, then they definitely won’t be able to prevent a 50% (or more) collapse in stock prices! 

The Fed does not have the stock market’s back, because the Fed simply is not powerful enough.

The second important point about the 50% collapse in government bond prices — and the accompanying rise in interest rates — is that it will likely lead to a major collapse in stock prices. This is due to the simple math of how stock prices are valued: the value of any stock is the value of all its future cash flows discounted back to the present at a market interest rate. 

Future cash flows, particularly over the next year or two, will be severely pressured by a recession, which is virtually guaranteed given the rapid rise in interest rates and the inverted yield curve, as we discussed in our recent Member Q&A and elsewhere. And much higher interest rates will dramatically reduce the present value of those future cash flows.

How much will this pressure stock prices? As we discussed in detail in our recent Member Q&A “What do current stock market valuation levels imply for future returns?”, the answer is: a lot!

Economist and fund manager John Hussman has done excellent work on stock market valuations and potential downside risk. As Hussman summarizes his chart below, “Historically, the completion of a full market cycle has typically restored prospective S&P 500 total returns to the higher of a) their run-of-the-mill 10% historical norm or b) 2% above prevailing Treasury bond yields. At present, the S&P 500 would have to lose about 64% of its value to restore those norms.” That implies the S&P 500 falling to about 1600!

Source: Hussman Strategic Advisors

Investment Implications

Investors are engaged in a massive case of wishful thinking when they believe the Fed can prevent a recession and stock bear market, given all historical evidence to the contrary. 

The huge rise in interest rates over the past couple of years, driven by the highest inflation rates in 40 years as a result of the Fed’s incredibly irresponsible 40% increase in the money supply in response to a virus, is virtually guaranteed to cause a major recession and bear market, as we warned about over two years ago. 

Now is the time to buckle up and prepare to profit — instead of lose — from the latest Fed-created disaster.