The Return of Greenspan's Conundrum and a Market Crash?

Back in 2005, then Fed Chair Alan Greenspan expressed frustration that despite hiking the Fed’s target rate six times, by a total of 150 basis points, long-term interest rates barely budged. He called it a "conundrum." (Years later the Fed's own research would provide evidence of the tenuous connection between the federal fund rates and long-term yields). 

Well, it's important because not long after in 2006 the yield curve inverted and not long after that the global financial system crashed. As Cullen Roche of the Pragmatic Capitalist notes the conditions today seem eerily familiar:

• Prices are rising across the board at an uncomfortable pace
• The Fed is getting worried about all of this and has started discussing potential rate hikes
• The long end of the curve has barely budged

However, back in 2005, the benchmark 10-year Treasury yield was hovering around 5%, today it's at 1.5%. As Roche notes, if the Fed starts raising rates they don’t have the same 5% of wriggle room before the curve starts to invert. "They have barely any room at all." 

As of now the bond market is strongly signaling that it thinks “inflation is transitory.” To use the gambling analogy to financial markets (which seems apropos), the bond market is the casino...and the "house" always wins (well, almost always). So the Fed is in a precarious position of having to choose between saving the financial markets (which is not in its mandate, but you know, the "wealth effect") and controlling inflation (which is a part of its dual mandate). Sure, sure this time it's different; after all, in the mid-2000s there was a massive housing bubble...but only in hindsight. Could the same not be said about a corporate debt bubble today?

Regardless, it's a fascinating exercise for portfolio managers. Inflation and the potential Fed hikes should be bad for bonds. Yet, the dangers of an ensuing bear market will likely cause fixed income assets to surge! Quite the conundrum? So, do you allocate 60/40 to stocks and bonds or 40/60 or even 20/80? Perhaps it's time for gold to finally shine again.