I don’t have a daily post for you today. So, in lieu of a daily, I wanted to make some more general comments about interest rates that I have been making in my market commentary pieces.
The accelerated hike timetable
In February, I wrote a post saying, “The march higher in US interest rates will continue“. And the thrust of that piece was that the market meltdown we were seeing then was an outgrowth of the market’s coming to terms with a more hawkish Fed. Powell was prepared to raise interest rates more aggressively than Yellen had done – and not necessarily because he was more hawkish. We were simply at a later stage in the economy and the pace of rate hikes increases as a result. Yellen might have done the same, had she been given another term by Trump.
I add the comment about Yellen because I previewed the hawkish tilt by the Fed three months prior, in November 2017, when I wrote that “We are in the most dangerous period in the business cycle“.
As I put it then:
I think this is the Fed’s real conundrum this late in a business cycle. If the economy is running solidly and leading economic indicators are bullish, the Fed is hard-pressed to not raise rates in an environment in which headline unemployment is low and falling, asset prices are rich, and lending standards have loosened — even if the yield curve is flattening. Aren’t they supposed to take the punch bowl away?
So, forget about the howls of protest from Trump, blaming the Fed in advance of an economic slowdown, saying he thought Powell was a low interest rate guy. This is exactly what one should expect at this stage in the cycle. I’m not saying this is how I would run things. I’m not in Powell’s seat. So I don’t know what I would do. But I can say this is totally expected — as is a further rate hike acceleration in 2019.
How the market reacts
The key to this is how the shifts happen in phases. As I put it in my February post:
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.
Here’s the thing though; when we hit 2.85%, the market threw a tizzy. And there was a lot of market volatility. But when we got to 3% in May, the equity markets were just fine. Instead, the reaction was in the bond markets, with the curve flattening from about 50 basis points between two and ten-year rates to just 18 by late August. Basically, after we scaled the 3% level, bond markets were throwing a tizzy.
But that was sort of the low for both bonds and stocks. Equity markets went straight up from there. And the Treasury yield curve steepened to about 35 basis points in early October, double the late August level, but a level still much lower than it was in May. That steepening got us to 3.25% on the 10-year and the markets threw yet another tizzy. This time it was equities that got killed. And just as in February, there was a massive flight to safety, causing yield to drop.
This is over now. The market is now comfortable with 3.25%. So, it’s on to the next level, maybe 3.50%on the ten-year.
When does it end?
It is going to go on like this, with yield surges and retracements until something breaks. Again, as I said in February:
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.
We are seeing that feed through now. Autos were first, and then came housing. We have even seen mild tremors in the bond prices of bubble stocks like Tesla and, most recently, WeWorks. I expect 2019 to be more difficult on this plane. First, we have to get through the holiday retail season. Let’s see if Sears gets liquidated, for example. And then we can start to make some predictions about where this is headed.
For now, it’s still smooth sailing. The economy in the US is still humming along. Wages are up. Inflation is up. And the Fed is on high alert as a result. Credit markets are not coming unstuck, just yet though.
My advice: watch the 10-year Treasury yield and the yield curve. Steepening means we have more time for this to play out. Flattening is a sign of stress. And increasing rates are the pin that eventually pricks the balloon.