Bond market predictions

[WendyBG]

https://www.wsj.com/articles/investors-bet-fed-will-need-to-…

**Investors Bet Fed Will Need to Cut Interest Rates Next Year to Bolster the Economy**
**In rare wager, investors expect a quick U-turn on rates: more increases this year, then cuts next year as economy weakens**
**By Sam Goldfarb, The New York Times, July 25, 2022**

**As the Federal Reserve prepares to meet this week, Wall Street investors are betting that officials will raise interest rates aggressively through the end of the year — and then turn around and start cutting them in six months.**

**The unusual wager reflects investors’ growing sense that the Fed is driving the economy into a recession as it tries to fight inflation, analysts said. At the same time, by constraining longer-term borrowing costs, it makes a recession slightly less likely to happen soon. That is a boost to riskier assets such as stocks, compared with a more traditional bet that rates wouldn’t boomerang so quickly....**

**Interest-rate derivatives, such as overnight index swaps, showed investors expect the Fed to raise its benchmark federal-funds rate by three-quarters of a percentage point on Wednesday. The Fed is subsequently expected to lift the fed-funds rate to around 3.3% by the end of the year. But investors expect no further increases after that. And they are betting that the Fed will be cutting rates by June, bringing short-term rates to roughly 2.5% by the middle of 2024....** [end quote]

I wish that the Fed would settle on a fed funds rate that would asymptotically approach a stable rate and then hold it there instead of raising it until a recession ensues and then cutting it to stimulate the economy.

https://stockcharts.com/freecharts/candleglance.html?$IRX,$U…

https://stockcharts.com/freecharts/yieldcurve.php

The Treasury yield curve is flattening as the short-term yield is rising but the 10YT and 30YT yields are declining.

The 5-Year, 5-Year Forward Inflation Expectation Rate is 2.12% so the real yields of the Treasuries are very low although positive…if inflation actually does subside to the expected rate.
https://fred.stlouisfed.org/series/T5YIFR

It looks like the bond market is predicting a successful Fed campaign to slow inflation. The lower borrowing costs will take the pressure off companies, helping support the stock market.

That doesn’t mean that there won’t be a recession.

It doesn’t mean that zombie companies (about 10% of listed companies) will have the cash flow to roll over their debts, since the entire yield curve is higher than it was a year ago and likely to stay there. The spread of zombie debt (CCC-rated and below junk bonds) is elevated to 11% over those higher Treasury yields. So the highly indebted “high growth” companies will still be pressured which will depress their stock prices.

https://fred.stlouisfed.org/series/BAMLH0A3HYC

Wendy

[Leap1]

I wish that the Fed would settle on a fed funds rate that would asymptotically approach a stable rate and then hold it there instead of raising it until a recession ensues and then cutting it to stimulate the economy.

The traders may not think the FED would be the cause of a recession.

Oil and energy
Tariffs

China’s financials melting down. The trading desks can see their own books. There is no where really to off load the swaps. Except to package them in things like ETFs? Or other funds. Still there is not enough room in those vehicles for the swaps. And later on the financials would be sued for fraud. Wont stop most of them though.

[Leap1]

Wendy et al,

The economy is already in a recession. The traders are betting the FED has to respond to a recession in the middle of 2023. This means the recession by mid 2023 is going to be deep!

This is very much an echo of the 1947 - 1949 recession.

[bjurasz]

I wish that the Fed would settle on a fed funds rate that would asymptotically approach a stable rate and then hold

I went to college at a private engineering school (Rose-Hulman). But I went for computer science, not engineering per se. What that means is I never took classes in control systems, but I know just enough about them to be dangerous. And control systems, which are meant to control some physical process, actually cannot do so precisely. As just one example is the computer in your car that reads values from various sensors and adjusts the fuel flow into the engine. The goal is to put in just the right amount of fuel, so that it is neither too rich nor too lean. But you never actually are able to do that. Rather, you oscillate around the optimal, going a bit rich, then leaning out too far, then going a bit rich again. Hopefully the magnitude of the oscillations is not too severe, but it will be there.

Same thing with the Fed I think, you oscillate around ‘optimum’. The problem, it seems, is the Fed’s magnitude of their oscillations is too great. Maybe they need to take a class in control systems?

[DrBob2]

Same thing with the Fed I think, you oscillate around ‘optimum’. The problem, it seems, is the Fed’s magnitude of their oscillations is too great. Maybe they need to take a class in control systems?

A couple of thoughts on control systems and feedback:

• The Fed actually depends upon the economic markets for their control systems. A Fed rate increase changes other interest rates across the curve (they have no control over longer term rates). The changed interest rates send multiple signals across many markets and, for example, housing starts go down. Prices for commodities change. The Fed becomes a watcher of the ripple effects.

• High frequency feedback can improve the control system, and there are more sources of high frequency data now. For example, the St. Louis Fed uses daily data from Homebase, a payroll processing company, which are useful in tracking employment in real time.
  www.stlouisfed.org/publications/regional-economist/third-qua…

On a side note, the Swiss audio company Soulution uses very high frequency negative feedback in their amplifiers.
https://www.theabsolutesound.com/articles/soulution-711-ster….
"Of course, some of us (at least some who go back that far) remember those Japanese solid-state amps from Sansui and others that also boasted record-low THD figures—but sounded like crap. The trouble was that to achieve such stellar specs the Japanese engineers had to ladle on so much global negative feedback that their amps were virtual TIM (transient intermodulation distortion) and SID (slew-induced distortion) generators. Feeding back the signal from the output in order to compare it to the signal at the input (and thus fix any errors that may have accrued as it made its way through the circuit) works fine if that feedback process is instantaneous, but feedback is a disaster if the amp takes too long to make its corrections…

"In concert with the company’s owner and CEO, Cyrill Hammer, Soulution’s engineers decided that it wasn’t feedback itself, but the speed at which the feedback loop operated that was the problem…

“Soulution found ways to do this very thing, reducing propagation delay times (the amount of elapsed time it takes to correct a signal via feedback) to 5–10 nanoseconds (billionths of a second), where big solid-state amps typically had propagation delay times of 1–5 microseconds (millionths of a second). This thousand-fold increase in speed allowed for a huge increase in local negative feedback (and a drastic lowering of THD levels), without the usual price paid in time-domain errors.”

DB2

[MrPlunger]

I wish that the Fed would settle on a fed funds rate that would asymptotically approach a stable rate and then hold it there

This assumes the system is stable … which it isn’t.

Say a 1% real rate is the sweet spot that is just right. But then if inflation just goes up a tad … the real rate has gone down! But to push inflation back down you need a higher rate not a lower rate. So the Fed has to tweak. And in practice it is usually late tweaking and so has to tweak a lot when it does.

It’s like balancing a fork vertically on your hand. You can’t hold it still. If the fork leans left, you have to move your hand more to the left to stop it falling over … you’re always reacting and countering.

So the Fed is always going to be tweaking and tweaking or they’ll let the economy run wild out of control in one direction or the other … as they just did …

[FreePuncher]

“That doesn’t mean that there won’t be a recession.”

1Q22 GDP = -1.6% Final

2Q22 Latest estimate: per Atlanta FED. -1.6 percent — July 19, 2022

As defined, a recession happens when 2 successive quarters of negative growth occur.

BEA will announce first estimate on 7/28/22 7:30AM EST

We’re already in a recession, Thursday’s announcement will only confirm it.

2/10 yield curve already inverted. Bond market is screaming recession.

The question for the FED will be, does recession trump inflation? If so, maybe some relief in sight for the stock market. If not, look out below.

fp

[Leap1]

The FF hikes and run off of bonds are not the only reason for the recession. Fiscal policy is not in place to support economic growth.

The FED will keep hiking. This is not a deep recession. Inflation must be tamed.

There are two things going on here that matter more. The FED is normalizing US rates, the USD is appreciating which will bring down input costs.

The second thing, the Chinese are reverting to a norm without their peg to the USD. I am not saying they take the peg off. I am saying market forces with the peg in place are damning their financial system. The value of the Chinese economy is way overblown.

In the OP the trading desks are betting on FED rate cuts in mid 2023. That is based on how deep the recession will be by then. Again the recession is not deep now.

[ptheland]

I wish that the Fed would settle on a fed funds rate that would asymptotically approach a stable rate and then hold it there instead of raising it until a recession ensues and then cutting it to stimulate the economy.

I’m sure the Fed would like to do that, too.

But it’s not going to happen.

It’s critical - especially for those trained in the hard sciences (chemistry, physics, for example) - to remember that macroeconomics is not really science. It is psychology. It’s based on estimates of what people may or may not do. And those estimates are, by nature, imprecise. To make things worse (or perhaps harder) things are constantly changing. New businesses are born that make some bit of the economy more efficient. Old businesses die taking something with them. The priorities of people are constantly changing. Economists like to drag out charts and graphs and models, but any economist who doesn’t put some really big error bars around their numbers is fooling themselves and those who read their work.

All the Fed can really do is look at the current situation, then decide how to respond. Once they respond, they go back to looking at the situation and see what changed after their response (or non-response - doing nothing is a potential option for the Fed.)

I’d also point out that the Fed’s mandate has nothing to do with recessions. They are tasked with inflation and employment. If we go into a recession where employment stays high, there’s no reason for the Fed to react. They can keep raising rates to fight inflation while a recession unfolds - as long as employment stays up. And so far that seems possible, at least for a while.

–Peter

[TucsonBones]

I’d also point out that the Fed’s mandate has nothing to do with recessions. They are tasked with inflation and employment.

Thank you. In all the talk about the Federal Reserve’s inducement to raise short term rates, no one has pointed to the one and only criterion that the Federal Reserve is focused on, the tight labor market and wage inflation.
The Federal Reserve has to push unemployment numbers above 8% before there is no pressure on employers to offer higher wages. Powell, speaking before the Senate Banking Committee, agreed that the Federal Reserve and short term interest rates have absolutely no effect on the driving forces currently on inflation; energy, supply chain, and food prices. The only inflationary force that the Federal Reserve can effect is wages, and the only goal of the Federal Reserve is to create an economic environment where there are far few jobs than people seeking employment.
I submit that the Federal Reserve will continue this Monetary policy for sometime into 2023 or 2024 until there are millions of people seeking jobs // not millions of jobs seeking employees.

[ptheland]

no one has pointed to the one and only criterion that the Federal Reserve is focused on, the tight labor market and wage inflation.

I’m not sure that’s quite right. The Fed’s mandate is inflation in general and not just wage inflation.

From a public policy standpoint, there is a defensible argument that real wages have stagnated for the last 3 or 4 decades. So there is some need for a bit of wage inflation.

As you noted in your post, the general inflation we’re seeing is only marginally caused by wage inflation. The bulk of the inflation drivers seem to be on the supply side, from factory shutdowns in China to the war in Ukraine disrupting the supply of food as well as oil and gas.

Increases in interest rates can only serve to slow down the economy in general. That can help a little bit by reducing demand and bringing it just a bit closer to the reduced supply currently available. But the Fed can’t increase supply.

Increasing supply would take fiscal policy, not monetary policy.

I submit that the Federal Reserve will continue this Monetary policy for sometime into 2023 or 2024 until there are millions of people seeking jobs // not millions of jobs seeking employees.

I don’t entirely disagree here. I suspect one criteria for stopping the rate increases will be the unemployment rate rising above 5%. Because the feedback mechanism between the real economy and the Fed’s decision making is pretty slow, the unemployment rate is likely to rise beyond that 5% level. But if it gets as high as 8%, I’d look for the Fed to start becoming more accommodative - but only if inflation (general inflation, not just wages) is deemed to be under control. Just to toss a number out, I’ll guess that inflation over 5% will trump unemployment and cause the Fed to stay with tighter monetary policy. Powell does not want to see a repeat of the late 1970s stagflation, and will be willing to trigger a recession (or more likely allow the current recession to continue, since we are almost certainly in a recession at the moment - just waiting for the score-keepers to confirm what most are already feeling in their pocketbooks).

–Peter