Interest rate futures

https://www.wsj.com/articles/feds-stern-message-amplifies-wo…

**Fed’s Stern Message Amplifies Worries About Stock Valuations**
**Inflation and the path of interest-rate increases have sparked debate over market valuations in the current environment**
**By Karen Langley and Nick Timiraos, The Wall Street Journal, The Wall Street Journal, June 14, 2022**

**...**

**One source of concern is the risk that the Fed’s tightening will push the economy into a recession, damaging both business fundamentals and investor sentiment. More immediately, higher interest rates reduce the value of companies’ future cash flows in frequently used pricing models....**

**One concern for financial markets is that bond investors are beginning to anticipate not only a sharper path of increases, but a higher destination or so-called terminal rate for the Fed. On Tuesday, investors in interest-rate futures markets placed a nearly 89% probability that the Fed would lift rates to around 4% or higher by June 2023. That market-implied probability was at 1% four weeks ago, according to CME Group....** [end quote]

The pricing model (net present value of future cash flows) uses the interest rate as part of an exponential function. Because of this, any change in the fed funds rate will be magnified exponentially in the valuation of a company.

The companies that are most vulnerable to massive declines in share value are the “growth” companies with high-yield debt (which will need to be refinanced at higher rates) and no profits so they are forced to roll over debt.

Bond holders will also suffer declines in the nominal value of their assets. The longer the duration, the bigger the loss. A bond loses about 1% in value for every 1% rise in prevailing interst rates multiplied by the years of duration. An investor who owns individual bonds can choose to hold them to maturity in order to receive the full par value. But an investor in a bond fund will see the Net Asset Value of the fund drop. A fund has no maturity.

Trillions of dollars of investments in stocks and bonds will evaporate as yields rise.

The Fed has said that it is aiming for a “neutral” fed funds rate which will neither stimulate nor reduce growth in the economy. Even a 4% fed funds rate will have an extremely negative REAL yield if inflation does not cool down.

The MSM has speculated so much about the Fed’s 0.75% increase that the market has not been surprised. The stock market appears to be calm so far.

https://www.wsj.com/articles/fed-raises-rates-by-0-75-percen…

https://www.federalreserve.gov/newsevents/pressreleases/mone…

New projections showed all 18 officials who participated in the meeting expect the Fed to raise rates to at least 3% this year. The median projection would lift the fed-funds rate to around 3.375%, or by an additional 1.75 percentage point over the following four meetings this year.

The dot plot shows a fed funds of 3.5% in 2023 and 2024, falling to 2.5% in “the longer run.” They predict inflation to fall to 2.2% by 2024 and unemployment to creep up from 3.5% to 4%.

This is an optimistic forecast that doesn’t show a recession caused by the rate increases. Fed Chair Powell has predicted a “softish” landing, whatever that means. It’s possible that there will be a recession and the Fed’s good intentions about controlling inflation will fly out the window as unemployment rises. That could lead to stagflation.

Either the entire Treasury yield curve will keep rising or it the slope will become negative at the short end, a reliable predictor of recession. A recession would directly strike at stock prices since sales and profits generally fall during recessions.

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

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

All asset prices (stocks, bonds and real estate) were artificially pumped up to bubble levels by excessive monetary stimulation. If the Fed actually executes its plan to return to neutral monetary policy, all asset prices will revert to the mean valuation – they will drop a lot from current levels.

Wendy

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The market is rallying hard on the news though. It’s almost as if they are more concerned with the impact of inflation than they are of the impact of higher rates. Perhaps they should be.

I am guessing that they are more concerned with inflation: both to take action & to be seen as taking action. I am also guessing that low unemployment mitigated their concern about the impact of higher rates.

The thing about rate hikes to combat inflation is that we can never get much past “wait & see” to know if it’s too much or too little.

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One source of concern is the risk that the Fed’s tightening will push the economy into a recession, damaging both business fundamentals and investor sentiment.

As long as they can keep the “shortage” narrative alive, recession is not a problem.

Speaking of keeping the “shortage” narrative alive.

Stellantis to lay off workers at Sterling Heights stamping plant
Layoffs to begin as early as June 20 at Chrysler Sterling Stamping plant

It is currently unclear how many employees will be affected by the layoffs. The Sterling Heights plant employs nearly 2,000 hourly workers who make parts for Ram trucks, Dodge and Jeep SUVs and Chrysler minivans.

https://www.clickondetroit.com/news/local/2022/06/15/uaw-ste…

That stamping plant is on Van Dyke in Sterling Heights. Just north of it is the assembly plant that cranks out those expensive and profitable Ram 1500 pickups. I went by the plant last Sunday on my way to a car show in Utica. I could smell the paint shop, so the place was running, on a Sunday. But, lay off people, cut production, keep the “shortage” narrative alive to maintain prices, but make the workers fearful of losing their jobs.

Steve

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That stamping plant is on Van Dyke in Sterling Heights. Just north of it is the assembly plant that cranks out those expensive and profitable Ram 1500 pickups. I went by the plant last Sunday on my way to a car show in Utica. I could smell the paint shop, so the place was running, on a Sunday. But, lay off people, cut production, keep the “shortage” narrative alive to maintain prices, but make the workers fearful of losing their jobs.

They make A LOT of money on those Rams, a lot (in fact, pretty much all their profits come from these types of larger trucks/SUVs). I guarantee that Stellantis wouldn’t cut production if they had any choice in the matter. It is a FACT that many of the parts they need to build the vehicles aren’t arriving, or aren’t arriving on time, it IS NOT a fact that they are purposely creating a shortage of Ram pickups.

4 Likes

They make A LOT of money on those Rams, a lot (in fact, pretty much all their profits come from these types of larger trucks/SUVs).

Ayup!

Give the people what they want at a price they’re willing/able to pay and you’ve got a sale.

– Desert Dave (Quotation, with attribution, permitted and encouraged. :wink:

1 Like