The bond market says short term rates will soon decline. The Fed says they will not.
There’s more than one way to find the former statement in the markets. One is in Fed funds futures, where traders wager directly on the Fed funds rate target. Another is in the Treasury yield curve.
The first is straightforward … the implied Fed funds rate, or the probability distribution of Fed funds rate targets, is widely published. I’ve referred to it on occasion when speculating about what the Fed is likely to do; not least because it’s a pretty accurate guide … partly a self-fulfilling prophecy since the Fed doesn’t like to surprise and also because it’s generally been keen on providing guidance as to its intentions.
The second way is a less direct. Bond market investors always have a choice when it comes to investing over any particular time frame. An investment to be made for example for two years can either be made by simply buying a two year note or by buying a one year note and reinvesting in another one year note when the first matures. Or any sequence of shorter term bills. And the US Treasury market is very big and very efficient. So the one and two year yields contain information on what investors expect one year yields to be next year. More generally the yield curve contains information not only as as to what yields investors are getting for a range of maturities but how they expect shorter term yields to evolve with time.
As it turns out, both give similar information about where the bond market expects short term rates to go. As of yesterday, for example, the four month yield was 5.26% and the six month yield was 5.24%. Because to cover six months, traders have the option of buying a four month bill then a two month bill or a six month bill (among other combinations), this tells us they expect short term yields to be a bit lower between four and six months out than for the first four months. Note this applies to Treasury yields, not Fed funds specifically. I prefer the latter because Treasury yields are more relevant to the financial markets (you can invest in Treasuries but not Fed funds) and because the Treasury market is much larger than the Fed funds market, but the two tend to track closely. See the yield curve chart below.
So what about the schism between FOMC forward guidance and the market outlook? The market rules. The Fed understands this. But if that’s the case, why would it nevertheless guide differently?
The thought processes of FOMC members are not observable variables. So such questions are inherently matters of speculation. With that in mind, mine is that the FOMC may have two possible motives.
One is that to whatever degree it can influence longer term yields, it would rather have them higher than not. The yield curve is profoundly inverted, and all else being equal, it would rather have the term structure of rates less extreme, relying less sharply on supershort interbank rates alone in favor of spreading out the upward pressure on rates.
Another is that it wants the public to shift more of its funds into banks and money markets. If you’re on the fence about whether to do so, you’re more likely to take the trouble to move money if you think the higher rates will last a while than if they’re about to revert lower. But why would the Fed want the public to shift more into banks and money markets? Well, where would it come from? At least some would come from longer dated bonds, exerting upward pressure on longer rates. See Point One. And some of it would come from stocks.
That is, the Fed wants stock prices to fall. This might smack of wild speculation, but there is more evidence for this. Fed speakers spoke quite a bit last year about enlisting tightening “financial conditions” as an aid in reducing consumer price inflation. One component of “financial conditions” is stock prices. Most pointedly, in one post FOMC press conference last year, a reporter told Fed Chair Powell the stock market was rallying in response to the FOMC announcement. Powell immediately ticked off a list of hawkish talking points, triggering a several hundred point loss in the Dow. It was so striking Bloomberg TV anchors remarked on it. Not just my imagination … Powell wanted to hammer stocks.
It is my belief that this explains why the Fed has remained this hawkish this long. Despite wishful reporting on the matter, it has not announced a “pause”. Never mind raised Fed funds by five full percentage points in barely a year. Stock prices have been rising partly on the premise that the Fed will soon pause, even start cutting. That may turn out to be the case if the bond market has its way, but the conditions that would prompt the Fed to cut would not be bullish for stock prices. Not only does the Fed usually hike until “something breaks”, but it likely wants something to break. It would not be a policy “mistake”. Stock bulls may be banking on rate cuts to rally stock prices, but they’re putting the cart before the horse … a decline in stock prices is what would prompt the rate cuts, providing the tightening of financial conditions the Fed seeks. Another round of asset price deflation (leg down in stock prices) could be just the ticket to knock consumer price inflation down into the Fed’s target range.
Treasury yield curve charts typically expand the time axis for shorter maturities and compress it as you go out the curve. Not without good reason … most of the interesting stuff is usually in the shorter maturities … more happens in the first ten years than in the last. I’m departing from convention here though in order to give a little more big picture perspective. The time axis is linear … 0-30 years with each year given equal time.
Notice the deep inversion of the yield curve out to around five years. Also interesting is the zigzag in the first year, likely associated with investors dodging potential default risk in the 1-3 month time frame. My view is that this more reflects media hype about the debt ceiling drama than genuine default risk, but that risk isn’t zero.
Regardless, the inversion of the yield curve is real, and it’s spectacular.
2 thoughts on “Cognitive Dissonance”
the story i’ve heard about the yield curve is that it’s pricing in 2 disparate scenarios: higher for longer ,and deep cuts if the economy/stock market/debt ceiling crashes. it’s schrodinger’s yield curve.
Hahaha … Schrödinger’s yield curve … excellent!
Skepticism about “this time is different arguments” is always justified, and this is no exception, but it’s worth at least being aware of the things that are different. All of our previous experience with inverted yield curves was under a “scarce reserves” regime. The Fed is now running an “ample reserves” regime, where it’s supporting short interest rates in part by paying banks interest on excess reserves.
Does this affect the message of the yield curve? I don’t think so, but the possibility has to be acknowledged. Fortunately the message has other supporting evidence, like the narrow breadth, etcetera we noted under Sell in May?.