The yield curve has steepened to where 10-year yields exceed 2-year yields by 52 basis points. That’s a healthy margin. This steepening shows Fed policy finally feeding through to the long end of the curve. Rising inflation expectations seem to be the catalyst.
The late cycle rate hike regime
Just last week, Fed officials were defending their policy stance given a renewed flattening in the yield curve. The fear was that the economy was rolling over and that the Fed’s stance would exacerbate the problem. The Fed said flattening was typical of rate hike regimes and was no cause for concern.
And, indeed, the 1990s was just as flat for the entire late 90s bull market. I said the Fed and other central banks would look past recent economic slowing and continue to raise rates.
But as this week began, all of that was out the window. Interest rates have skyrocketed, climbing even more on the long end of the curve than the short end. And yesterday equities sold off hard. While this may seem like a case of market whiplash, it’s not. It’s what should be expected in a late cycle rate hike regime.
Here’s how I put it in mid-February:
Yesterday, after the inflation report came out, I wrote that 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 as they did just recently. 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.
It’s all about the volatility
The constant here is increased market volatility. And that’s due to the increased uncertainty of a rate hike regime. For seven years US interest rates were at zero percent. And while various unconventional policies accompanied zero rates, the one constant was zero. That lent a degree of certainty to Fed policy. And this certainty led to falling long-term rates.
Had the Fed continued down the path of zero rates, long-term rates would have fallen inexorably toward zero as they have done in Europe and Japan. But now the Fed is tightening. And the question is two-fold because we don’t know what the incoming data will look like. And we also don’t know how the Fed will react to those data. That makes for volatility. And this volatility will last until we get certainty that the rate hike regime is over.
So, now we have 3% on the 10-year. What next?
I expect more curve flattening. And so I am looking for the curve to flatten to 25 basis points in the next few months. That means 3% has become the new 2.85%, the level which initially triggered this wave of bond and equity market volatility. If inflation expectations rise, then long-term rates will rise toward 3.25% from here. But eventually they will rise so much that panic will set in, equity markets will fall out of bed and the curve will flatten again. This time it will be to 25 basis points.
That’s my baseline. None of this has anything to do with the real economy, by the way. It is all psychology and expectations driven. The real economy is still doing well enough that, outside of a monumental economic shock, recession seems to be a remote possibility. The Fed regime change and expectations about the Fed’s reaction function are driving rates now much more than the real economy.
When to get bearish on risk assets and bullish on bonds
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.
At one point, Bonton was considered a speculative borrower. But as rates rose, the leverage caught up to it and Bonton became a Ponzi borrower. And it defaulted. The unique thing with Bonton is that it may go into liquidation. The Columbus Dispatch says the liquidation has already begun. And that’s going to have a very negative real economy impact in Pennsylvania and the surrounding states.
In the last economic cycle, I flagged Linens ‘N Things as a similar credit because I looked at it as largely indistinguishable in terms of brand from Bed, Bath and Beyond. The biggest difference was the financial distress. The end result was liquidation and the loss of thousands of jobs. But this was later in the cycle, during a financial crisis.
In this cycle, once the Bonton Effect begins in earnest, the Fed will have to swiftly move into reverse. If it doesn’t, that’s when you really need to think about risk off strategies to protect your wealth. In the near-term, remember that two hikes are off the table. The question is now 3 or 4 for 2018 and how many beyond this year. In that regime, positive economic and inflation surprises will lead to interest rates increasing. But, again, at some point the worry will switch to the real economy impact and then we will get a big selloff in equities and a rally in bonds. And this volatility will continue for some time.