Exclusive: Wall Street is in for a rude awakening, former NY Fed president says

Wall Street threw a fit last week when Treasury rates spiked. The stock market tanked and investors feared the economy was overheating. Former New York Fed President Bill Dudley is warning that the temper tantrums are only just beginning.

“They want the economy to overheat,” Dudley told CNN Business, referring to the Fed. “And my personal opinion is, I wouldn’t sell them short. I think they are going to be successful.”

Inflation worries lifted the 10-year Treasury rate to 1.6%, well above the 0.3% it tumbled to last March. That unnerved investors, who have become accustomed to rock-bottom rates that make stocks look attractive by comparison.

Low bond rates underpinned the V-shaped recovery on Wall Street and encouraged investors to pile into risky assets — everything from unprofitable tech companies and GameStop to trading cards and blank-check companies known as SPACs.

But Dudley, who was speaking after appearing virtually at a conference held by the Institute of International Bankers, thinks stocks are going to have much more competition from boring bonds in the months and years ahead.

“Moving to 1.6%, that’s nothing,” said Dudley, who left the NY Fed in 2018 after nearly a decade there. He predicted Treasury rates will eventually climb to between 3% and 4% — or higher.

And that’s a big deal because risk-free Treasuries are the yardstick by which all other investments are valued. Just as ultra-low rates make stocks look attractive, higher rates would steal serious thunder from stocks.

“The bond market right now is a little bit unrealistic about their expectations for the Fed. They certainly want the Fed to stop this,” said Dudley, who was previously a top economist at Goldman Sachs. “And I think the Fed’s view is, no. We’re not going to stop this. This is normal. This is what happens when the economy looks like it’s going to actually recover.”

Recovery hopes on the rise

To be clear, talk of inflation and an overheating economy is a welcome change, especially given the dire straits last spring when the pandemic erupted.

It means there is growing confidence in the recovery, especially as the vaccine rollout accelerates and Congress moves closer toward enacting a $1.9 trillion relief package.

Unlike the sluggish recovery from the Great Recession, economists are hopeful of a more rapid rebound that gets the economy back to full employment. Goldman Sachs is now calling for 7% GDP growth in 2021 — a level of growth unseen in the United States since 1984.

“My personal view is we’re probably going to see a pretty strong economic recovery,” Dudley said, pointing to the powerful actions from Congress and the Fed. (He cautioned, however, that much still depends on defeating the pandemic.)

Bond market bubble fears

But all of this optimism, piled on top of easy money from the Fed and aggressive stimulus from Washington, is raising concern about bubbles emerging in financial markets.

Asked whether he sees any bubbles in markets and what areas are most concerning, Dudley pointed the finger squarely at the bond market.

The former NY Fed chief said it will be a “big adjustment” for investors when Treasury rates climb back to between 3% and 4% because “extraordinarily low” rates have supported stocks.

“I don’t see an equity market that’s particularly expensive relative to the bond market,” Dudley said. “What I see is a bond market where yields are extraordinarily low.”

Dudley said he’s not sure if he would use the word “bubble,” but said low Treasury rates are “absolutely not” sustainable.

“If you define a bubble as something where yields are far away from where you’re going to be in the long run, then I guess it’s a bubble,” Dudley said.

The Fed is arriving late this time

One key difference between this recovery and the last is that after years of undershooting the Fed’s 2% inflation goal, the central bank wants inflation to overshoot 2%.

That means the Fed may not rush to raise interest rates until inflation is solidly above that 2% level. The decision to allow inflation to run hot is aimed at boosting employment, easing inequality and avoiding the specter of deflation.

“The Fed has basically changed its regime from one where they would try to arrive on time, to one where they’re now going to arrive late,” Dudley said.

But that may mean the Fed will need to act more aggressively to catch up when it finally raises interest rates, perhaps in 2023 or 2024.

“Because they’re late, they’re going to have to do more. It means that interest rates will go up by more, they will go up faster, once the Fed finally starts to tighten,” Dudley said. “That’s just going to be a tougher thing for financial markets to digest.”

Celebs are getting into SPACs

Higher rates, whenever they arrive, will act as a deterrent for some of the more speculative activities on Wall Street.

For instance, investors have plowed staggering amounts of money into SPACs — shell companies with no operating assets that exist to take private companies public.

Even celebrities are getting into the SPAC game, with Shaquille O’Neal, Alex Rodriguez, Colin Kaepernick and pop star Ciara all getting involved in blank-check companies.

“It does seem to be a little bit on the hot side when everybody wants to set up a SPAC,” Dudley said. “I worry about too many SPACs chasing too little supply.”