Why the ten-year’s hitting 3.25% has spooked asset markets

This is how Fed tightening regimes work

We’re bracing for another big sell off in equities today. I don’t know if you saw my piece yesterday on market groups breaking below 50- and 200-day daily moving averages. I said “I don’t have a view on whether this is important. But the technicals are weak.”  For me, this is part and parcel of a late-cycle Fed tightening regime that I described in February.

…as inflation expectations increase, the interest rates investors will accept will climb slowly. Equity markets won’t throw a fit at 2.85% interest rates… Instead though, it could be smooth sailing until 10-year interest rates hit 3.00%. And then we see more market volatility. But once that level settles in, the acceptable rate might climb to 3.25%. And we will repeat the process all over again.

This is how late-cycle interest rate hike regimes work. But at some point, there will be a negative impact on credit and that will feed through into the real economy.

That’s what I wrote back in February. And that’s what’s happening right now.

Bear steepening is a signal the market believes the Fed could be behind the curve

The 10 or 15 basis points of bear steepening that we saw recently now looks to have been limited. We are still at a level where the 10-year trades at 32 basis points more than the 2-year. So the curve is, indeed, somewhat steeper than it was in August or early September. But the same dynamic that began with the regime shift is still with us. And it is saying that interest rates will go up in waves before asset markets gets spooked and sell off. We are seeing one such episode now.

I still see the market shift to bear steepening as significant though, because it is a marker for the market’s realization that the economy is resilient enough for the Fed to continue to raise rates more than it has guided for. In short, the market now believes the Fed is behind the curve. How dos it deal with that though?

Up until now, the concept that the Fed was behind the curve meant steepening as the market believed any rate hikes would not derail economic growth or earnings growth. But we are seeing a big hiccup, doubts about that argument. That’s what the equity sell-off, bond rally means.

I believe this episode will pass in due course, with the market now inured to the 3.25%, resulting in a march higher from here. It’s take us a really long time to get here because the bond market rally after we hit 3% was so extended that it almost seemed we wouldn’t get to 3.25% before the curve flattened into inversion.

But we’re here now. And the Fed is signalling more rate hikes are to come. We’ll just have to see how the real economy holds up.

The initial real economy impact

My baseline is that the US economy powers through 2018 with some pockets of weakness. We are seeing that weakness in the interest-sensitive housing sector. But the latest GDPNow reading that came out yesterday still shows 4.2% for Q3 growth. That’s up from the previous read of 4.1%, with just over two weeks left before we see the actual number.

I think Reuters has it right:

Rising costs for companies are worrying investors already concerned about a step down in U.S. corporate profit growth next year as Wall Street’s focus turns away from 2018’s tax-fueled earnings boost.

My view: This will pass. Equities are not headed for a bear market just yet.

Instead, as Neil Irwin puts it, “interest rates are rising for all the right reasons.”

“The long end of the yield curve has finally moved to the view that this could be a more persistent recovery,” said Michelle Meyer, head of U.S. economics at Bank of America-Merrill Lynch. “It’s reflecting the possibility that this recovery has further legs.”

But, crucially, the higher long-term interest rates don’t seem to be driven by expectations that inflation will soar higher.

Credit distress in 2019 and beyond is the key

Back in April, I talked about what I called “the Bonton effect,” when perfectly healthy retailers go bankrupt.

As I said in February, “at some point, there will be a negative impact on credit and that will feed through into the real economy.” The question is when. My assumption is that the Fed will continue to raise rates right up until the curve is almost completely flat. And at that point, it will pause. We will then see how the existing policy stance feeds through into credit markets and the real economy.

Telltale signs that tightening is having an effect will come via increased high yield default rates and company liquidations. Let’s call it “The Bonton Effect”. I think of Bonton, the Pennsylvania retailer that just declared bankruptcy, as an intrinsically healthy department store. But it is struggling with changing industry dynamics and a mountain of debt.

This isn’t Sears here. I don’t see the imminent bankruptcy of Sears as a “Bonton Effect” bankruptcy. But a Tesla would be. And I anticipate we are going to see this kind of distress in the latter half of 2019 if not before.

In the meantime, watch for signals that we are moving to four rate hikes in 2019 in addition to four in 2018. This may be enough to push us into distress. But, then again, it may not be. It’s just too early to tell.

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