For the past few weeks, the bond market has been in frenzy. After sitting listless for months, U.S. yields have shot up sending the benchmark 10-year rate above the 2.5% mark on Monday. Just a few months ago, that same rate stood at 1.75% so we‘ve basically made a 40% plus gain in yields in less than eight weeks.
What caused such massive change of sentiment? Trump of course. The election of Donald Trump has created one of the greatest capital outflows in history, as investors dumped bonds and poured money into equities on the assumption that we are about to enter Reaganomics 2.0.
Whether Mr. Trump can juice the economy remains to be seen. He has yet to even take the reins of power, but the market is now so far ahead of itself that I think the Fed will step in and stop the party before it gets out of control.
The conventional wisdom is that finally, (finally!) after all these years, after pouring trillions and trillions of dollars into the bond market to liquefy the system, the Fed will begin to normalize monetary policy and start raising rates in a predictable manner.
Don‘t hold your breath.
|Experts expect the Federal Reserve to raise rates tomorrow..|
Don‘t get me wrong. There is almost no doubt that the FOMC will hike rates by 25 basis points tomorrow. In fact, the Fed funds markets are forecasting 100% chance of that event happening. But that move is already well priced in. The rally in yields is all about the next year and Fed‘s return to a once-a-quarter rate–hike schedule.
This is where I believe the markets will be sorely disappointed tomorrow. While speculators have been in a giddy frenzy shorting bonds, the Fed officials are starting to panic. Their plan to normalize rates depends on a slow, steady trickle of tightening credit that does not strangle the economic recovery.
With rates already well ahead of where the Fed wants them, the housing market is starting to suffer as mortgages and refinancing are no longer that attractive. Although rates are low in the absolute sense, in the financial markets it‘s always the relative basis that matters most. Since election day, 30-year mortgage rates are up by more than 20%. That kind of shock to the system bodes badly for housing demand in 2017 especially as wage growth remains anemic.
Which brings me to my second point. With all the hoopla about growth and recovery, one statistic glaringly stands out — wage growth remains depressingly weak. In the last NFP report, average hourly earnings actually fell by -0.1% despite the economy adding another 178K jobs. The Fed is clearly mindful of that fact, and it will resume “business as usual” until wage growth shows a clear and definitive uptrend.
Little wonder then that even a well–known Fed hawk such as St. Louis President James Bullard thinks that one–and–done may be enough for now. Last week he stated that in the absence of any change in policy, the U.S. economy will need only one rate hike through 2019 to reach a neutral rate given that inflation and unemployment are close to the Fed‘s target.
|We believe that market expectations are grossly misaligned with the Fed‘s policy intentions.|
We believe that market expectations are grossly misaligned with the Fed‘s policy intentions. We‘ll be trading the FOMC meeting with our Calendar Profits Trader members tomorrow, and it will no doubt be yet another massively volatile day in the markets.
But while the majority of market opinion thinks that we are just months away from “normalcy“, we disagree. As someone on Twitter recently noted, tongue planted firmly in cheek, “The Fed is in the business of raising rates once per year.“