Yesterday the Federal Reserve’s FOMC Minutes confirmed what we’ve been thinking – that the Fed will find a way to justify higher-inflation without rising rates faster.

But what really made me laugh were comments made by James Bullard – President of the St. Louis Fed Bank.

He said that the yield curve has a “nice slope” and there is currently no danger of an inverted yield curve. But – ironically – the yield curve got even closer to inverting after his words and the FOMC’s comments about expecting a rate hike in June. This news was supposed to make the spread widen.

Looking at the 2 n’ 10 Rule – the spread between the 2-year and 10-year rates – we still see the spread at its tightest since the 2008 recession. Remember, the last 9 out of 10 recessions were preceded by an inverted yield curve.

And today there is only a 0.46 spread between the two rates – and it’s closing in on negative.

So, what yield curve ‘slope’ is Mr. Bullard talking about? 

Besides his comments, what’s worrying me is that the annual inflation is well above the Fed’s ‘2% target’. And – even worse – the FOMC believes now this could be “helpful”. Since when is paying more for goods and services helpful?

The only thing helpful from all this was two revelations from the Fed Minutes.

First Revelation

We now know that the Fed will run the economy hot with inflation instead of hiking faster. The Fed could’ve justified hiking during the last meeting because of how much inflation is rising.

But they know that the very fragile U.S. economy can’t handle rising short-term yields. . .

Rising yields makes it harder for debtors to service their debt. And with American consumers indebted up to their necks – and the U.S. government’s growing deficits requiring more financing – this would be very damaging. One big example, banks depend on borrowing ‘short’ and lending ‘long’.

What this means is that banks and hedge funds borrow short term debt and invest the funds in the long term high-yielding market.

For instance, a local bank will borrow from the Fed at 1.75% then turn around and lend it out to a mortgage customer at a fixed rate of 4.5%. Their ‘nominal’ profit (before subtracting inflation costs) being the difference – which is 2.75%.

Many economic crises have happened because of short term rates shooting higher then long-term ones. It creates illiquidity problems. And many bank runs have started from this. So now that we know the Fed will put up with much higher inflation than their ‘2%’ target rate – like we expected – but how much higher is yet to be seen.

Second Revelation

If the Fed is hiking rates, unwinding their balance sheet through Quantitative Tightening – selling their bonds – and with inflation already at 2.5% and rising, why are investors buying 10-year bonds only yielding 2.99%?

Inflation alone is killing the ‘real’ gains – for instance, a 2.99% yield minus 2.5% inflation equals only 0.49% ‘real’ profit.

That’s more than an 85% ‘real’ loss. 

And since the Fed said they’re okay with even higher inflation – that means the 10-year bonds bought today are facing serious ‘real’ losses. So, the real question is – “why are investors today buying long dated bonds when the Fed is hiking rates, running Q.T., and inflation is rising?”

Shouldn’t investors be selling their bonds and asking for higher yields to protect themselves from the coming inflation and rate hikes?

The only answer I can think of is that the bond market is calling the Fed’s ‘economic growth’ bluff. They understand that the U.S. economy is fragile. And that the chance of deflation and recession is very likely within the next few years.

If bond holders expect an economic slowdown and deflation ahead, then they know the Fed will quickly reverse their tightening, begin cutting rates, and start buying bonds through another round of Quantitative Easing.

And when bond yields go down – that means bond prices go up.  

If this scenario plays out, that makes the currently ‘not-so-profitable’ bonds suddenly very profitable. . .

Bond investors are the ‘smart’ investors – so if they’re calling the Fed’s bluff, it’s very concerning. These two revelations give us an idea of what’s really going on. The economy is too weak for more hikes, and the bond market isn’t buying into the mainstream medias growth story.

The 2 n’ 10 Rule shows that the yield curve is dangerously close to flattening – then soon afterwards inverting. And not even rate hikes, Quantitative Tightening, or rising inflation is enough to shake this trend.

Sorry, Mr. Bullard, but we’re calling your bluff.