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Market Snapshot 09.22.23 – Talk About The Fed

Good Friday AM,

No news today other than the BOJ keeping their rate stance the same. Bonds are finding a little bit of a bid which is overdue. Let’s see if it gets any legs.

For now, I guess we go back and talk about the Fed.

The Federal Reserve is hoping for something it has never managed before: not merely the softest of soft landings for the economy, but the slowest rate-cutting cycle in its history. Fed officials plan to cut rates next year less than investors hoped (why markets jumped), but then spread rate reductions over another three years, as inflation decelerates despite little in the way of job losses. It’s the perfect scenario for the central bank, but history suggests it isn’t likely to work out. Almost every interest-rate cycle ends with rapid rate cuts, and never before has there been such a drawn-out series of rate cuts as the Fed now forecasts, James Mackintosh writes.

Ok, I am going to geek out a bit on this next piece.

I actually cut it down quite a bit but it is a really interesting deeper dive into bonds and rates. The highlighted last paragraph is the punch line and says it succinctly if you don’t want to look at the pretty graphs…

… If there’s one more or less clear signal to unite this week’s global round of central bank meetings (with the eternal exception of the Bank of Japan, which left rates unchanged and still hasn’t started to hike), it’s that by and large they hope they’ve reached a plateau. The Swiss National Bank and the Bank of England sprung significant surprises by opting not to raise rates at all, while last week’s European Central Bank meeting did see a rate rise, but also made a concerted effort to convince the market that it might well be the last. Sweden’s Riksbank hiked to 4% Thursday, but sent strong signals that it was done. So maybe we’ve scaled the top of Table Mountain:

The analogy works all the better because hills shaped like Table Mountain, with a wide flat top, aren’t that common. Triangular peaks are more usual. And if we look at the course of history, we tend not to see Matterhorns, so much as moves more reminiscent of the Torres del Paine, at the southern tip of Chile.

Now, let’s look at the fed funds rate over the last two decades, and over the fateful 20 years starting in 1971. Rates were altogether higher in the ’70s and ’80s, so they’re on different scales, but the Paine-like shape is common to both:

Rates tend to move like this because monetary policy is about tightening until something breaks.

If a financial crisis or a recession breaks out, rates will have to come down fast. Measured, Matterhorn-like decreases are unusual. And they will now have further to fall, as these central bank announcements have been accompanied by a significant upward breakout in bond yields. In Asian trading, the 10-year Treasury yield reached 4.5% for the first time since the eve of the Global Financial Crisis in 2007 — the kind of landmark that people in the markets will notice. Part of this tightening was passive; the dot plot indicated yesterday that rate cuts next year are likely to be slower to come. But part of it was simply an acknowledgement by the bond market that until recession hits, yields are going to have to keep rising.

Looking further into the increase in yields shows that this is a genuine tightening.

The 10-year yield can be split into a rate to cover expected inflation (the breakeven rate), and a remaining “real yield.” The former responds to alarms about inflation, while the latter can be treated as the driver of whether conditions are truly tight. Substantially all of this year’s move has come from higher real yields, while fears about inflation have actually abated a little:

The latest step upward is roundly attributed to Jerome Powell of the Fed. The Fed’s projections imply an economy with “more underlying momentum than previously believed and that there is less need to crush the job market to bring inflation back into line by 2026.”

That means that the Fed’s “bullishness,”, is pushing up rates. Unless and until the Fed succeeds in “breaking something” — a large institution, or the economy — yields will be under pressure to rise.

Please remain safe and stay healthy!