The collective wisdom of bond market participants accepts that the 40-year-long trend in which each economic cycle requires fewer Fed rate hikes is intact. The Fed’s “terminal rate” is currently priced at around 1.85%, up from the current 0.25%, according to the one-month forward OIS curve. This means the market is predicting the Fed will boost rates by around 50 basis points to 75 basis points less than the previous cycle high before the economy or markets force another easing cycle.

The bond market is wrong.

Prior to the Covid crisis, every economic downturn was met by the Fed encouraging more private sector credit expansion. This became progressively more difficult as the private sector had more debt than the previous cycle, which meant it took lower rates to encourage more borrowing and required fewer rate hikes to stall the economy.

However, the massive fiscal deficits from the pandemic response had a dramatic effect on private sector balance sheets. Many Wall Street strategists have an aversion to government deficits, but it’s an accounting identity that the government’s deficit is the private sectors’ surplus. In other words, the government’s red ink is the private sector’s black.

During the financial crisis, many bond market participants were concerned that extraordinary monetary expansion would cause an explosion in inflation. But monetary velocity collapsed as there was little demand for money and even less supply due to tightening credit conditions.

Few investors seem concerned now about a sustained uptick in inflation because they assume velocity will stay muted. But, what if improvement in the private sector’s balance sheet has sowed the seeds for the next great credit expansion? 

Many investors highlight the falling birth rate among millennials as a contributor to the past trend of disinflation. For millennials, lack of career opportunities and financial burdens certainly weighed heavy. However, the labor market is now approaching levels of tightness not seen in decades and the fiscal stimulus has improved consumer balance sheets considerably. 

The amount of U.S. household debt as a percent of GDP has fallen from a high of almost 100% coming out of the last recession to around 75% currently. Combined with a decrease in rates, this means that debt service as a percentage of disposable income has not been lower in more than 40 years.