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

“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 be successful.”

Inflation is worrying raised the 10-year government interest rate to 1.6%, well above the 0.3% it tumbled to in March last year. That uninvested investors, which has become accustomed to bottom interest rates that make equities look attractive in comparison.

But Dudley, who spoke after appearing almost at a conference hosted by the Institute of International Bankers, believes equities will face much more competition from dull bonds in the coming months and years.

Wall Street new bogeyman: the bond market

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

And that’s a big deal, because risk-free government bonds are the yardstick for valuing all other investments. Just as ultra-low interest rates make stocks look attractive, higher interest rates would steal serious thunder from stocks.

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

Recovery hopes to increase

To be clear, talk of inflation and an overheating economy is a welcome change, especially given the serious difficulties last spring when the pandemic broke out.

This means that there is a growing confidence in the recovery, especially as vaccine rollout accelerates and Congress approaches adopting a $ 1.9 trillion relief package.

Unlike the sluggish recovery from the Great Recession, Economists are hoping for a faster rebound which gets the economy back to full employment. Goldman Sachs is now calling for 7% GDP growth in 2021 – a level of growth not seen in the US since 1984.

“My personal view is that we are likely to see a fairly strong economic recovery,” Dudley said, pointing to the strong action by Congress and the Fed. (However, he warned that much is still due to defeating the pandemic.)

Bond market bubble fear

But all this optimism, piled on top of simple money from the Fed and aggressive stimulus from Washington, raises concerns about bubbles popping up in the financial markets.

When asked if he sees any bubbles in the markets and which areas are most affected, Dudley pointed the finger entirely at the bond market.

The former NY Fed chief said there will be a “major adjustment” for investors as Treasury rates climb back to between 3% and 4% as “extraordinarily low” interest rates have supported equities.

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“I do not see a stock market that is particularly expensive relative to the bond market,” Dudley said. “What I see is a bond market where returns are extremely low.”

Dudley said he was not sure if he would use the word “bubble”, but said low government interest rates were “absolutely not” sustainable.

“If you define a bubble as something where the return is far from where you will be in the long run, I guess it’s a bubble,” Dudley said.

The Fed arrives late this time

An important difference between this recovery and the last one is that after several years of falling short of the Fed’s inflation target of 2%, central bank wants inflation to exceed 2%.

This means that the Fed may not want to rush to raise interest rates until inflation is above the 2% level. The decision to keep inflation warm aims to increase employment, reduce inequality and avoid the ghosts of deflation.

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“The Fed has fundamentally changed its regime from a place where they would try to arrive on time, to one where they will now 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 are late, they will need to do more. That means interest rates will rise more, they will rise faster, when the Fed finally starts tightening,” Dudley said. “It’s just going to be a tougher thing for financial markets to digest.”

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Higher prices, when they arrive, will be a deterrent to some of the more speculative activities on Wall Street.

For example, investors have plowed dizzying sums of money into SPAC shell companies without any operating assets available to disclose private companies.

“It seems to be a bit on the hot side when everyone wants to create a SPAC,” Dudley said. “I’m worried that many SPACs are hunting for too little supply.”