January 2025: A Tale of Two Rates

A Recap of the May 2023 Forecast

Back in May 2023, amidst the political drama of raising the debt ceiling, I shared a letter highlighting debt and inflation that is mostly memorialized as a May 2023 summary blog post. The congressional tug-of-war was more of a sideshow compared to the looming economic issue: the likelihood of sustained, higher-than-average inflation.

I pointed out that the US national debt, already at $31 trillion, indicated a fundamental economic imbalance that temporary political solutions would not fix. My argument was that policymakers would most likely choose the path of least resistance when facing this debt—allowing inflation to run its course rather than implementing drastic spending cuts or tax increases.

Default or debt restructuring? Politically, these are as welcome as a storm at a barbecue. Inflation, while not ideal, was the lesser evil.  Furthermore, politicians would much rather blame "unexpected" market movements or global events than admit to orchestrating inflation through monetary policy.

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Fast Forward to 2025: A Tale of Two Rates

Now, in 2025, my prediction seems to be materializing. Long-term interest rates have climbed, signaling the market's acknowledgment of persistent inflation, while the Federal Reserve has opted to lower short-term rates to spur economic activity. Typically, lowering short-term rates should depress the entire yield curve, reducing borrowing costs universally.  The bond market isn’t buying what the Fed is selling.

If investors see inflation or government borrowing spiraling out of control, they demand higher yields for long-term bonds to offset the risk of a weakening dollar and higher inflation. Thus, we see "a tale of two rates": the Fed pushing down short-term rates (what they can control), while the bond market moves the opposite way on long-term rates.

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The Debt Problem Isn’t Going Away

I previously mentioned in my December letter that I am cautiously optimistic that the new Department of Government Efficiency (“DOGE”) is a step in the right direction for our country’s fiscal problems.  As of January 2025, the reality from 2023 persists: the federal debt continues to balloon, with no significant resolution to the structural budget deficits. This environment, shaped by years (if not decades) of monetary policy to mask fiscal irresponsibility, sees bondholders demanding higher returns due to doubts about the dollar's future purchasing power.

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What This Means for You

1. Inflation Erodes Purchasing Power: Inflation is a stealth tax, hitting hardest those with a fixed income or wages not adjusted for inflation. Pay attention to the real return on your investments or request a raise from your employer if you’re a salaried employee.
2. Long-Term Rates Affect Borrowing & Investing: Whether you're looking at a mortgage, business loan, or other financing, long-term rates are crucial. The Fed's influence here is limited if inflation expectations remain high.
3. Diversification Remains Key: In this environment, a diversified portfolio that includes assets resistant to or benefiting from inflation adds protection.
4. Expect Market Volatility: The tug-of-war between short- and long-term rates will likely cause market turbulence. Ensure you have liquidity to avoid forced sales at low prices.

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Looking Ahead

There's a debate on whether the Fed will intentionally allow inflation to rise to chip away at the real value of the national debt, reminiscent of post-WWII strategies to deal with the debt. The question is, will we see this again, and to what extent?  I think the answer is yes.   A lot of really intelligent people agree and disagree with that prediction.

Regardless, the main advice is to remain agile. My writing from 2023 is still relevant: diversify, consider inflation, and avoid over-reliance on any single asset class, particularly long-term bonds, where you're betting on promises decades into the future.

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