Market shift to bear steepening as important as regime shift under Powell

Back in late February, I told you there was a new hawkish tone coming from the Fed that I believed meant an acceleration of the Fed’s rate hike timetable. When Lael Branard got onboard, I knew a regime shift was at hand.

This has proved to be the right assessment as far as 2018 goes, with the Fed now signalling four rate hikes, up from three at the beginning of the year, and well above the less than two hikes implied by the market.

Behind the curve

But now we are almost near the end of 2018 and it’s time to look forward. As we do so, another regime shift seems to be at hand and that’s from the market’s belief that a Fed tightening cycle will crush the economy to one in which the Fed is seen as ‘behind the curve’.

Now, I use the word ‘seems’ because we are only talking about 10 to 15 basis points of steepening between the 2-year and the 10-year treasury. But in the context of a market that seemed to be moving toward inversion, this is a big turnaround. And it is happening against the backdrop of increasing short-term rates, meaning long rates are moving doubly fast. The 10-year sits at 3.25% right now and the 30-year is trading at 3.42%.

Atlanta Fed President Raphael Bostic’s comments which I just reviewed are critical in that regard because he’s saying that the Fed is behind the curve. And a Fed that’s behind the curve in a market that believes the expansion has legs is one in which long-term rates could go up quite a bit higher from here.

What’s the impact?

I’m not clear yet on where this is going. In part, that’s due to the uncertainty surrounding the pace of economic growth going forward. But, if the economy maintains a decent measure of momentum, it’s hard to see the Fed not accelerating rate hikes. And it’s hard not to see that acceleration feeding through into the long end of the curve.

My own view is that the downside for long bonds is limited in part by the speed of that move, meaning an accelerated move higher in yields sows the seeds of its own destruction by pulling the credit cycle end forward. The Goldilocks scenario is one in which yields march higher, but not high enough to create credit distress. How high is that level? That’s complete guess work, especially since we would have to see the rising Treasury yields translate into rising corporate bond yields.

If you look at the last two cycles, taking rates up about 1.75% in 18 months from 1999 to 2000 produced recession. In the next cycle, rates went up for 18 months before you got the initial yield curve inversion in January 2006. And that was an increase of 3.25%.

Fed rate cycles.png

Source: St Louis Fed

Here, we’re talking about 2% over the two years 2018 and 2019. It may be enough to push us into distress. But it also may not be. It’s too early to say. Irrespective, we are at a critical juncture now. We got a regime shift by the Fed in February of this year. We now have a market regime shift that seems to be taking place as well. Both are equally important

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