“They want the economy to overheat,” Dudley told CNN Business, referring to the Fed. “And my personal opinion is that I would not sell them short. I think they will succeed.”
But Dudley, who was speaking after virtually attending a conference held by the Institute of International Bankers, thinks the stock will have much more competition from boring securities in the coming months and years.
“Moving to 1.6% is nothing,” said Dudley, who left the New York Fed in 2018 after almost a decade there. He predicted that Treasury rates will rise to between 3% and 4% – or more.
And this is big business, because risk-free Treasury bonds are the measure by which all other investments are valued. Just as ultra-low rates make stocks more attractive, higher rates would steal the stock boom.
“The bond market at the moment is a little unrealistic in relation to expectations for the Fed. They certainly want the Fed to stop this,” said Dudley, who was once an economist at Goldman Sachs. “And I think the Fed’s view is, no. We are not going to stop that. This is normal. This is what happens when the economy looks like it is really going to recover.”
Hope for recovery up
To be clear, talking about inflation and the overheating of the economy is a welcome change, especially considering the terrible difficulties last spring, when the pandemic broke out.
This means that there is growing confidence in the recovery, especially as the vaccine launch speeds up and Congress is approaching to enact a $ 1.9 trillion aid package.
“My personal opinion is that we are likely to see a very strong economic recovery,” said Dudley, pointing to the powerful actions of Congress and the Fed. (He warned, however, that much still depends on defeating the pandemic.)
Bubble fears in the bond market
But all of that optimism, coupled with the Fed’s easy money and Washington’s aggressive stimulus, is heightening concern over bubbles in the financial markets.
Asked if he sees any bubbles in the markets and which areas are of most concern, Dudley pointed his finger directly at the bond market.
The former NY Fed chief said it would be a “major adjustment” for investors when Treasury rates return to between 3% and 4% because “extraordinarily low” rates supported the stock.
“I don’t see a stock market that is particularly expensive compared to the bond market,” said Dudley. “What I see is a bond market where yields are extraordinarily low.”
Dudley said he was not sure if he would use the word “bubble”, but said the Treasury’s low rates “are absolutely not” sustainable.
“If you define a bubble as something where yields are far from where you will be in the long run, then I think it is a bubble,” said Dudley.
The Fed is arriving late this time
This means that the Fed cannot rush to raise interest rates until inflation is solidly above the 2% level. The decision to allow rising inflation is aimed at boosting employment, reducing inequality and avoiding the specter of deflation.
“The Fed basically changed its regime from one that they would try to get to on time, to one that will now be late,” said Dudley.
But that could mean that the Fed will need to act more aggressively to compensate when interest rates finally rise, perhaps in 2023 or 2024.
“As they are late, they will have to do more. This means that interest rates will rise more, will rise faster, when the Fed finally starts to tighten,” said Dudley. “This is going to be a more difficult thing for the financial markets to digest.”
Celebrities are entering SPACs
Higher rates, whenever they arrive, will act as a deterrent to some of the more speculative activities on Wall Street.
For example, investors have injected astounding amounts of money into SPACs – shell companies with no operating assets that exist to go private.
“It looks a little positive when everyone wants to set up a SPAC,” said Dudley. “I worry about too many SPACs chasing too few supplies.”