While the stock market is the most common object of most investors’ attention, as referenced in Analyzing Ackbar two weeks ago on the day Silicon Valley Bank went down, the real action has been in interest rate markets - specifically short-term rates.
That table shows the evolution of various US Treasury yield levels over the past three weeks. The term ‘yield curve inversion’ means that shorter-maturity bonds have yields that are higher than longer-maturity bonds. As of March 8th when the yield on the 2-year Treasury peaked at 5.05%, one of the most common proxies people monitor, the 2-year vs 10-year, was inverted by 117 basis points (1.17%). Here is a longer-term perspective on this proxy:
We can see the severity of the recent inversion relative to history since 1976, with its level exceeding the other recessionary periods except for those in the early 1980s. Of course, the inversions of the early 1980s occurred with far higher nominal interest rate levels, and amidst a much less indebted economy.
As we can see from the chart, 2 vs 10 yields have typically steepened early in recessionary periods - i.e. the inversion is a pre-cursor and then the steepening augur recession. As of Thursday, the curve moved all the way to just -0.10 inverted - an explosive relative steepening in just two weeks!
Chairman Jay Powell referenced the uncertainty of potential credit tightening relative to tightening conditions in the economy at his press conference Wednesday, following the Federal Reserve’s decision to raise rates another 25bps. Effectively, he framed tighter credit conditions as potentially supplanting additional Fed rate increases - i.e. doing the Fed’s ‘work’ in slowing the economy, in a sense.
Rates markets have begun pricing in higher probabilities of rate cuts as early as this May, but my view is that things would have to get REALLY disorderly in the global banking system and financial markets to have the Fed reverse course with year-over-year CPI still over 6% and their supposed preferred gauge, core PCE, still at 4.7%. That level remains more than double their stated 2% target.
Eurodollar futures markets are often used as instruments to hedge and/or speculate on how interest rate policy will evolve over time. With the service sector and other components of the economy still reporting reasonable growth (like Friday’s services PMI), eurodollar futures have evolved in the past couple of weeks in a way that may suggest the Fed could be following a path similar to how they navigated the inflation cycle from 2020 to last year.
The following are hourly charts over the recent 10-day period for eurodollar futures for June 2023, September 2023, December 2023, and June 2024:
We can see that the three 2023 contracts remain below the spike peaks in price reached last week in the aftermath of the bank failures and subsequent concerns about bank runs. The June 2024 contract is the first in future quarterly increments to have ‘broken out’ and held so far.
Here is the March 2025 contract:
While markets are pricing in elevated probabilities of the Fed cutting rates in the coming months, the persistence of 2023 contracts may be indicative of pricing in the scenario of what many may see as a big policy mistake by the Fed - i.e. continuing to ‘fight’ markets and maintain the rates they control near current levels even as coincident economic data weakens and additional acute crises emerge in the coming weeks and months.
Similar to the tardiness they displayed in responding to the inflation cycle upturn that began in autumn 2020, will they similarly ‘screw up’ the business cycle downturn and march forward despite a severe synchronized global recession currently unfolding?
Chairman Powell and other Fed officials have been relatively explicit since last summer that they misjudged the inflation cycle, and that raising rates at an unprecedented pace was intended to reduce demand and increase unemployment significantly. They were/are unable to say they think a recession is required to address the inflation issue, but that has been their ‘unsaid’ expectation, in my opinion.
Since Powell’s Jackson Hole speech last August, I have been expecting policymakers’ reaction function to be slowed for a variety of reasons. For example:
Flush consumer and corporate balance sheets from pandemic-era stimulus delaying the timeline of those aspects of the economy ‘rolling over,’ as are still being reflected in data related to the service sector, retail sales, etc.
Policymakers playing with fire - i.e. the acceptance of recession would mean they are slow to respond and lack the appreciation of the dangers of the non-linearity of recessionary forces once they take root
The recency bias of the GFC, with many people focused on the issues of that cycle, rather than the specific dynamics and associated risks of the current cycle
The money illusion aspect of the current cycle, with high inflation driving high nominal economic activity that is decelerating rapidly
The Fed tried to resist what rates markets began pricing relative to the inflation cycle in 2021 and did not ultimately begin to relent until March 2022.
Even with their preferred measure of inflation having broken out above its 2007 peak in April 2021 and detached from its 2% target, the Fed took over a year to begin to act with any policy vigor.
Why should we all expect their level of competency to result in them responding to a sharp downturn in the economy in a swift and decisive fashion? What happens if/when markets begin to suss this out?
What I’ve laid out may suggest rates markets are incorporating such a scenario, but equity markets appear to remain very complacent. Markets have a way of doing such things, as long-term Treasury bonds displayed relative to the recent inflation cycle.
Look how long into the inflation upturn long-term Treasury bond prices held up - into December 2021!
Resistance will be futile once again, in my opinion, but the Fed appears as if it may make a go of it nonetheless. And Jay Powell is no Jean-Luc Picard.
I find your analysis very compelling. You have hit some nails bang on their head! Another way to say what you said, i.e. the fed stuck with the transitory narrative for too long. They were wrong. What this makes me think is either their models were wrong, or they intentionally waited too long. Are supposed to think that with around 700 pHDs at the fed they do not know what they are doing? I know it is a matter of opinion whether a PhD actually means anything but what does it mean when 700 pHDs are wrong? My personal opinion is that they have a bad case of group think going on. Anyway I think you are on the right track. Looking forward to your next post.
Thank you Kayfabe. So, the take away here is that Market forces are in control of interest rates overall. The FED can do little to influence interest rates at this time. The banking issues as of late have "reset" the curve steeper [ less inverted] and recession chances have gone up and have been brought forward. Is it possible that the banking fears are overblown? That the programs instituted by the FED to help the banks by buying them time [and time is the real problem here correct] will work and with time, that these banking fears will abate? So my way of thinking is that between low unemployment, sticky inflation and a banking crisis that fades away in a few weeks, couldn't this push interest rates higher again? Albeit not where they were before SVB. Your thoughts would be appreciated. Thank you sir.