An epic battle between the bond market and the Fed is setting up. It may be a monumental one. For the past year, the Federal Reserve has been pumping money into the system via bond-buying and a zero interest rate policy. These accommodations allowed our economy to sidestep a potential second Great Depression, or perhaps even worse.

The Fed knew that at some point, the economy was bound to recover. If it didn’t, all that money in the system would create some big problems in the form of inflation. Inflation is the boogeyman the Fed has been fighting for more than 40 years. Fixed-income investors (bondholders) fear inflation. In fact, they are so obsessed with it that the bond market has called the last two recessions.

Since the beginning of the pandemic, the bond market has taken the Fed’s monetary policy in stride. Investors knew that if/when inflation were to perk up, yields would rise and bondholders would sell their bonds (rather than fighting inflationary fans). Totally normal behavior.

A battle between the bond market and Fed?

Here’s where things may get hairy. Interest rates are slowly rising on the back end of the curve. It appears the Fed is tone-deaf to what might be happening. Or are they? Last week, Chair Powell made a statement about the economy and what needs to happen for a full recovery. Simply put: Stay the course.

The bond market sees things differently though, and we’ll soon find out who is driving the bus. Will the Fed eventually see the inflation winds blowing, or will they allow the economy to heat up enough to spark rampant inflation?

Gold is often viewed as an alternative investment when the winds of inflation blow. We haven’t seen a stampede into gold yet, but we have seen a rush into bitcoin. Perhaps that is telling us something, too.