If the Federal Reserve shies away from its current policy of raising rates and tightening the money supply, it wouldn’t alleviate pressures in the market, at least not for long, according to investment analyst Michael Lebowitz. Instead, it may crush the economy.
As the logic goes, if bondholders are confident enough that inflation will go down to the Fed’s target of 2 percent per year, they'll be willing to hold bonds with relatively low yields. If the Fed returns to a loose monetary policy before such confidence settles in, bondholders will demand higher yields to offset the losses from inflation that they would expect to continue.
“The bond market’s going to throw up,” Lebowitz said. “Yields are going to go much higher and that has a circular effect on everything.”
If bond yields go up, so would the interest on mortgages and corporate loans, he noted, which in turn signals more corporate defaults and layoffs—in short, a recession.
“All that economic pressure that people may have thought was being alleviated because of the Fed’s pivoting—it’s actually the opposite,” Lebowitz said.
“It’s going to squash the economy.”
His argument goes against the basic idea behind the Fed’s policy of quantitative easing and tightening. If the Fed tightens, it means that it’s unloading some of the Treasurys it holds and tapering its purchases. Since this leaves more Treasurys on the market, the increased supply should prompt buyers to ask for higher yields.
It seems to have worked, in his view.
“So far, they’ve been able to slowly let the air out of the bubble,” Lebowitz said, explaining that higher interest rates and a little bit of tapering have so far shaved 20 percent off the stock market, but in an “orderly” fashion, prompting some loan failures, but nothing “extreme.”
“Will they be able to keep doing it?”
That’s unclear.
Lebowitz expects that the Fed will stop its tightening too soon.
“I don’t trust the Federal Reserve. I think they have, in the past, been so quick to save the financial community, so quick to save banks, to save hedge funds, to make sure we never have a recession,” he said.
Lebowitz acknowledged that the Fed has recently been hawkish, but questioned whether the central bank has really changed.
“Do I trust the Fed of the last four months or the Fed of the last 40 years?” he asked, noting that he would have to trust the latter.
If the Fed even just softens its rhetoric, it “may help financial markets in the very short run,” Lebowitz said, but he warned that it would be “a very deadly gamble.”