Fed Needs to Stop Selling Bonds

The market has seen a pullback in August. That’s not unexpected given that the market has been on a tear since June after the Fed paused its rate increases and the debt ceiling was raised.

However, another problem has been added to what is a normal market pullback – rising interest rates for the 10-year bond. The rate hit a high of 4.3% last week before falling back slightly. We wrote an article in early July indicating this was a risk because after the debt ceiling was raised, the Treasury sold lots of bonds at the same time the Fed is also selling bonds. Lots of sellers means buyers are going to demand higher rates to take down all those bonds.

The week before last, the Fed sold $60 billion in bonds – a lot for one week. But, last week it only sold $6 billion. No new trend yet though, so we must keep an eye on this issue going forward. As we have said before, interest rates are about the only normal fundamental driver of stocks that we need to watch closely.

Sometimes, the market will simply bring rates back down despite the Fed and Treasury both selling. Also, the Treasury will certainly not be selling at the same rate as it did in June when it had a lot of catching up to do.

But, if that doesn’t happen, the Fed will need to slow down its bond sales. Some market analysts expect that Fed Chairman Jerome Powell will address this issue at a speech on August 25. Most expect him to be supportive of keeping the 10 year rate from moving much higher because of the damage it does to the bond and housing markets.

We agree that he will likely be supportive of keeping the 10 year rate where it is, but I could be surprised. Powell has to be very careful about higher rates, not so much because of the stock market, but because of the bond market. Higher rates are not good for the bond market and Powell should be careful about letting rates get higher than 4.5% and especially 5%, lest he start to create a small panic in the banking and financial industries.

As rates go higher, he also risks turning a slowdown in residential real estate into a big drop. Not good to panic the residential real estate market. Lots of Americans own homes or would like to own a home.

The Fed has shown its sensitivity to these issues in the past, especially with the bond market, so we are holding our stock positions for now. But we are keeping a close watch on this situation – interest rates matter, more than anything else.