Bye, bye, bye "Lower for Longer"

September 22, 2023

These markets don't care until they do. And we shouldn't assume that central banks are in control within this environment despite the fact they are using the tools they have. If you revisit Chair Jay Powell's press conference the one thing that's blatantly clear is that after years of manipulated interest rates this Fed has no firm grasp on where rates belong. No one piece of data will skew us. Totality of data. We'll know when we know in cutting rates. And the neutral rate "could" be higher. Yes, hold on tight. 

Thank you, Fox Business, Mornings with Maria, and Maria Bartiromo for including us again this week!

Let's Take a Look: 

We reflect on the week. For us it's been about the length not the height for some time. One of our biggest themes of 2023 has been the pushback against rate cuts. And of late in our Fed preview highlighting the Fed's need to trim rate cuts formally. It felt like draining water from a rock heading into a meeting that wasn't live but it played out more aggressively in the Fed's numbers and market reaction. In the end, these are windows of time. One day at a time. Even one more rate increase is a coin toss. Come on Jay. If we don't know where neutral lies, think it's perhaps higher, AND as indicated in the presser what's the big deal of one more hike: JUST DO IT!

Higher for longer versus lower for longer. Boy, there are many market participants that have lived only one. And it's not higher. As we intimated in our segment with Fox Business yesterday morning, the full impact of these rate increases lies ahead in our view. It's been markets over the economy in reacting. No surprise here as the Fed created much of what was found in these bank portfolios. And for consumers, well it just takes time. Even Powell himself when questioned about economic resilience indicated: perhaps we haven't been restrictive for long enough. And we believe that's it. Higher rates need to marinate. More importantly, this recent shift in higher long term "real" rates essential for the Fed to succeed with inflation. 

The self-infliction in this moment is real. Anyone that has participated in markets over the past 15 to 20 years can see the evolution. Some may choose to ignore it, others more transparent. And we realize the playbook has changed, and we need to adhere to it. But many of the variables being dealt with today could (and should) have been avoided in many ways. Markets can be very efficient if left to their own devices. But leaving interest rate policy at artificially low levels for years has been extremely detrimental. And to think we layered a bazooka on top throughout the pandemic, created the biggest pocket of inflation in decades, and will land the plane with ease feels bizarre. No wonder Powell flip-flopped on a soft landing. And in the words of former St. Louis Fed President Bullard: the plane hasn't landed until we're at 2%. 

Ultimately, the bigger macro story is not about one more rate hike or not. Rates that remain higher than usual, and for longer, now that's a big story. The evolution of core inflation over the coming months and years another. But with markets that are often disconnected, repricing with narratives, subject to groupthink, these windows of time matter. And for this Federal Reserve, keeping the heat on financial conditions with real rates restrictive is a key ingredient to success. This week's Summary of Economic Projections was the closest thing to forward guidance we're going to get for now. For us, barring something unforeseen, it makes sense. But this has been a shocking move for consumers (2022/2023) and now the next phase of this cycle with a new normal. 

In the end, Chair Powell's approach in this moment is prudent. The economy is still being heavily influenced by fiscal policy. It can't and shouldn't be ignored. Across the country workers are nervous: AI, government policy, inflation, wages, job security, and more. Don't let the spending fool you. But to Powell's point, the surveys are weak because people hate inflation. True. But they keep spending. When we look at all these dynamics right now it resonates inflation. Wages growth may be slowing but the mark-to market shift matters. And the same with inflation; prices are not coming down, the increases have simply slowed. We don't want to land with stagflation. And despite a strong desire to believe the Fed's recent forecast, ambition; it doesn't seem likely. 

On the ground

The move in long end US real rates has been one of the bigger stories in the market. Granted, it's been hard to ignore the AI craze. We've been bearish (rates) throughout the summer and have highlighted the various reasons why. And because we form our macro views with an interest rate core, it's been hard for us to ignore the move toward and above 2% in UST 10-year real yields. These are rate levels that take us back a long way. In many ways we don't know. A 2% real 10-year UST yield today is not what it was 15 years ago. We are hearing that in Powell's message. 

With that, and as our Head of High Yield trading has been highlighting, supply demand factors are driving some of the price action away from US Treasuries. High yield being one. Nonetheless, all-in rates are looking better by the day. But spreads have tightened. And we believe higher real rates if sustained will work to continue tightening financial conditions further. To the extent it remains somewhat orderly, the Fed will not fret. Quite the opposite. But it's been a long, hard-fought year ridden with ups and downs. The potential for another rate hike in front of us. Liquidity likely to get worse not better as the year wanes. Just saying. 

US rates and yield curve. Locally, the UST 2/10 curve has room to further steepen (less inverted). The upper end of the range for the last year comes in around -40. So, another 25-basis points from here. And with context back to the 2006-2008 cycle, nominal 10-year UST spent time between 4-5.25%.

Our initial target in UST 10-year was 4.50%. But there is room to move higher from these levels which should we do so would likely include a less inverted curve. In the SOFR EDZ3/EDZ4 curve a continued reflection of the Fed's higher for longer narrative.

The move from the Fed in this week's Summary of Economic projections, like it or not, was meant to send a clear message. And did. 

 Have a great weekend!