by Neil Azous, Chief Investment Officer
- Taking Stock
- Mid-Cycle Adjustment a False Narrative
- The Next Evolution
- Where Does This End?
- What Does This Mean For Your Portfolio?
In our September 5, 2018, post “Yield Curve Inversion – What Does It Mean For Your Portfolio Right Now,” we said the Federal Reserve’s (the “Fed”) last interest rate hike for the cycle would be in December 2018. The roadmap we laid out advocated that the Fed would start cutting interest rates as soon as the summer of 2019.
Outcome: The last interest rate hike for the cycle was December 2018.
In our February 19, 2019, post “The New Narrative For Lower Interest Rates,” we double-downed on that view, reiterating that the US fixed income market continued to communicate that the Fed will likely be cutting interest rates by the end of the summer.
In our May 31, 2019, post “Fed Cutting Cycle – Our View Is Crystallized,” we illustrated that the US fixed income market was providing another key signal – when the cutting cycle will start (i.e., next three months) and end (i.e., Q4 2020-Q1 2021).
Outcome: The Fed cut interest rates at the July and September FOMC meetings.
While we are pleased to see our steadfast views come to fruition so far, what comes next is equally as important.
In today’s post, we provide supporting information that the Fed has embarked on an easing cycle that should last well into 2020.
Mid-Cycle Adjustment a False Narrative
We believe the message that the Fed is espousing – that is, the Fed is operating under the pretense of “a mid-cycle adjustment” – is a false narrative.
Historically, “mid-cycle adjustments” have been characterized as 0.75% of interest rate cuts when a short-term deceleration occurred within a longer economic expansion. These “mid-cycle adjustments” took place in 1995-96 and 1998.
Pointedly, to suggest that after 10 years of expansion, the latest interest rate cuts are a “mid-cycle adjustment” is misguided. Below we provide quantitative evidence to support our view.
To determine if monetary policy is too tight, the Fed has two preferred measures: the 3m/10y US Treasury yield curve and the 3m vs. 3m/18m USD swaps curve.
Sidebar: To see the Fed’s rationale for why they use these two measures, click HERE.
Currently, both of those curves remain deeply inverted. To identify the point where the Fed can lower the Fed funds rate such that these curves are no longer inverted, we analyze the “forward” iterations of them.
- The 3m/10y US Treasury curve is inverted out to 6 months forward (chart below for reference); The US interest rate market is priced for 0.43% of interest rate cuts over the next six months.
- The 3m vs. 3m/18m forward USD swap curve is inverted out to 18 months forward (chart not referenced); The US interest rate market is priced for 0.69% of interest rate cuts over the next 18 months.
It is important to note that in the 1995-1996 and 1998 “mid-cycle adjustment” interest rate cuts, these two forward yield curves were NOT inverted leading up to the third interest rate cut.
Therefore, because the US fixed income market remains inverted, and there is another 0.43% to 0.69% of interest rate cuts discounted in the market, the Fed will need to cut no less than 0.50% more, if not 0.75%, to cause the yield curve to no longer be inverted.
Note, despite high volatility in US interest rates over the last several weeks, these expectations have not had a major shift in the past two months.
The Next Evolution
The risk to the evolution of more interest rate cuts occurring than less lies at the October 31st FOMC meeting. The market-implied probability of a 0.25% interest rate cut at that meeting is 70%.
Note, the Fed has never not cut interest rates in an easing cycle when the market probability is greater than 50% four weeks ahead of the meeting. In a tightening cycle, the threshold is higher at 70%.
Furthermore, if the Fed skips October and waits to cut in December, the FOMC will have to explain a change in course twice, rather than keeping the continuity of a cutting cycle.
Collectively, following the 0.50% of interest rate cuts by the Fed to date, and another 0.50% to 0.75% cuts required to cause the yield curve to no longer be inverted, we believe it is likely that the Fed is at the beginning of a prolonged easing cycle and not near concluding a “mid-cycle adjustment.”
Where Does This End?
The financial system does not function optimally when there is a flat or inverted yield curve for a prolonged period, like now. Therefore, a key objective of this easing cycle should be to steepen the yield curve.
Furthermore, conditions cannot be “eased” unless the Fed cuts more than what is discounted in the forward curve. This is a primary driver of our view that the Fed will ease more aggressively than the current consensus in the market.
Ultimately, the fixed income market always underprices the speed and degree of Fed easing cycles, by orders of magnitudes.
For example, the dotted line on the chart to the right is the average market pricing walking into the beginning of an easing cycle. The other lines are the totality of the cuts. Many easing cycles are 4-5 times the amount priced in at the beginning.
Is it different this time?
We do not believe it is.
What Does This Mean For Your Portfolio?
It means that fixed income instruments linked to US Treasury yields are not done going up in price.
Our favored expression remains fixed income closed-end funds that stand to benefit from lower financing costs.
If you are interested in learning more about how we use our Federal Reserve model to take advantage of lower interest rates in a portfolio or make asset allocation decisions, please call us at 203-539-6067 or email us at firstname.lastname@example.org.
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