The Rate-Hike Narrative Hasn't Changed, It Has Shifted

Markets are growing worried about growth. As the Federal Reserve has become increasingly hawkish over the last couple weeks, we have seen cyclical stocks trade down, credit spreads widen, and the yield curve flatten further. So what are markets trying to tell us? Could this be an early sign of the Fed making a mistake? Here are my thoughts. Narrative Hasn't Changed, It Has Shifted As inflation ramped up during 2021, I was often asked why bond yields didn't seem to be responding. At the time the consensus within the bond market was that it wouldn't take much tightening from the Fed to quell inflation. Traders remembered what happened in 2018, where the Fed hiked just a bit too much, caused a growth scare, and wound up cutting rates in 2019. Many thought something similar could happen this time. I don't believe that consensus has fundamentally changed. While bond traders certainly think rate hikes are coming sooner and faster than was once assumed, markets haven't changed their view of where the Fed ultimately stops. The chart below shows the eurodollar futures market, which is essentially futures on 3-month LIBOR. It is the most liquid futures market for short-term yields, so it is generally a good gauge of longer-term Fed policy expectations. The blue line is today, the red line is June 1, 2021 and the green line is Oct. 1, 2021. Chart Source: Bloomberg What we see is that markets currently expect rates to rise rapidly to 2% and then hold there. But notice that this ending rate isn't any higher than markets were projecting in 2021. Indeed, it is slightly lower. Note that LIBOR is usually higher than fed funds, so that 2% rate here is probably more like 1.75% in fed funds. Probably no coincidence that 1.75% is also where fed funds ended up in 2019. This tells us that market consensus from last year is still the same: the Fed can only hike so much before causing the economy to slow. Once the economy slows, the Fed will stop hiking. What has changed is that that risk moment, the time when the Fed approaches this threshold where they may damage the economy, now seems likely to come much sooner. In June or October of last year, the eurodollar futures curve suggested some vague notion that eventually rate hikes would start and eventually the Fed would get to around 1.75% or so. Now we know all that could be coming quite rapidly. If that's the case, then the risk of a slowdown is also becoming more salient. As I've written before, I'm more optimistic than that. Or maybe more accurately, I'm more open-minded than that. It may well be that this consensus view comes to pass, and this winds up being a very short rate-hiking cycle. However, I also think it possible that the economy has more fundamental strength than is being presumed. If so, we should be open to the potential for significantly higher yields. Scant Evidence of a Slowdown in Hard Data Recent economic releases have been scoured for signs that Omicron has slowed the economy, but that evidence is quite thin. In the last week we got strong reports on New Home Sales, Durable Goods Orders, Job Openings and the ISM Manufacturing survey. The one weak spot was Personal Spending, which came on the heels of a weak Retail Sales report for December. But overall, this paints a picture of an economy that is humming. As an aside, there was a stir Tuesday after some White House officials seemed to indicate that Friday's Non-Farm Payrolls report might be weak, specifically because of people calling out sick during the survey period. First, readers should note that the White House doesn't get an advance copy of the report until Thursday evening. While their fears may well be justified (look no further than the -301,000 ADP report from Wednesday), they don't actually know what Friday's payroll report says. Also note that if indeed a large number of people were out sick the week of the survey, it will be pretty easy to tell. The Non-Farm Payrolls number is tabulated by asking companies how many people were paid that week. If an hourly employee called out sick all week, they didn't get paid, so they wouldn't count. However, the Household Survey asks individuals if they are employed. Obviously someone who had merely called in sick won't report themselves as unemployed. So if indeed what the White House fears is true, we'll get a weak Non-Farm number but a strong Household number. If that happens, markets won't have trouble interpreting it properly. High-Yield vs. Investment-Grade Spreads Now let's get back to what the market is telling us about growth fears by looking at credit spreads. Corporate bond spreads of various credit quality are almost always very highly correlated. You don't see BBB-rated bonds tighten while BB-rated bonds are widening. However, the degrees to which both are moving can be very telling about why spreads are moving. Since Sept. 30, BBB-rated corporate bonds have moved 22 basis points wider, while CCC-rated bonds have moved 60 bps wider (all according to Bloomberg data). For CCC, we only need to go back to November to find spreads this wide. For investment-grade, you need to go back to December of 2020. When there's a real growth scare, not only do spreads move much more rapidly, but the pain is much more acute in weaker credits. For example, in the fourth quarter of 2018, BBB spreads moved 60 bps wider while CCC widened by 418 bps. That's not to say this recent move wider in credit spreads is meaningless. I think it reflects the weak growth narrative discussed above: Fed rate hikes bring forward a potential risk, and that needs to be reflected in spreads. Still, readers should keep this in context. This is a very minor move in the scheme of things, and we shouldn't overreact to it. Tighter Money Does Slow Demand Again, I'm relatively optimistic that economic fundamentals are strong enough to withstand a number of Fed rate hikes. That being said, we should be real about the risks. No one knows how high rates need to go before money actually becomes tight. In fact, since monetary policy's impact only works with a lag, a central bank can't know the impact of policy moves in real-time. I've often said that when the Fed is tightening, they are like a car trying to back into a parking spot without a rear view mirror. They only know to stop when they hit the curb. Hence, I think we're going to have to learn to live with this uncertainty about Fed policy. I remain comfortable saying that the risks are skewed to the upside. If the Fed were to stop after hiking to 1.25% or 1.50%, longer-term bonds would rally but not that much. The 10-year probably ends up in the 1.40%-1.60% area in such a scenario. However if economic growth remains robust and inflation remains over 2%, the Fed is probably going to continue hiking. I think that leaves much more room to the upside than to the downside.

The Rate-Hike Narrative Hasn't Changed, It Has Shifted

When the Fed is tightening, they are like a car trying to back into a parking spot without a rear-view mirror. They only know to stop when they hit the curb.

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