There’s a problem in the money market, even if US 10Y rates stay below 4%

As bond yields move higher in response to bumper payrolls (Feb 3), Fed remarks (last week) and sticky inflation (Feb 14), there’s a lot of golly-gee commentary circulating. Generally, the comments take the form of “Look, the US 2Y yield keeps rising” or “Wow, the 2s10s curve keeps inverting”, without specifying why a certain level of yields or curve spread matters for the economy, for Equities and Credit, and for timing the start of the always-anticipated 2023 recession. So below is my quick take on what’s material in the bond market currently. 

First, watch the terminal rate that is being priced rather than its cousin the US 2Y.

Second, adjust that terminal rate for expected inflation and compare it to US potential real GDP growth.

The two series are plotted in the chart above, which presents one simple summary of how loose or tight monetary policy is and what that rate setting does to the economy. Periods of a real Fed funds rate well below potential growth are stimulative, because the central bank is attempting to price capital below the rate that would balance supply and demand for consumption and investing in an expanding economy. Periods of a real Fed funds rate above potential growth are restrictive, because the the central bank is doing the opposite — it is forcing the price of capital above equilibrium in order to contain an imbalance like too much inflation. 

Importantly, periods of a real funds rate above potential growth almost always end badly. That monetary setting triggers #recession, as shown by the blue bars that follow overshoots in the real funds rate. The only exceptions were the run-ups in 1984 and 1994, both of which the Fed quickly pivoted away from due to low and stable inflation.

Even before the money markets repricing of the past two weeks, the Fed was clearly aiming to take the real funds rate above potential growth by the end of this year. Here’s the arithmetic from the December SEP. The Fed projects a 5.1% terminal rate and 3.5% core PCE inflation rate by end-2023. That’s a +1.6% real funds rate if take literally, but a 2.1% real funds rate if adjusted for the 50bp of additional tightening that the Fed estimates its balance sheet shrinkage is worth. US potential growth is estimated at 1.7% to 1.9%, so below the Fed’s target. Obviously, another 25bp move in the dots at the March meeting, as the US money market has priced this month, would only add to this overshoot.

Flagging the rising likelihood of a recession due to rising real cash rates does not help in the most challenging aspect of 2023, which is timing the start of that contraction and the end of this last hurrah rally that has been supporting Equities and innovation assets (Crypto, Exponential Tech, Hydrogen) this year.

I still think that the best timing tools are 1) economic surprise indices, which are still positive due to China reopening and Europe’s fading energy shock; and 2) the US corporate profits recession, which began in 2022 Q4 but still requires another quarter or two to trigger payroll losses that will break current complacency.

So invest in the hurrah if you’re are comfortable timing this late-cycle, lowish risk premium phase. But, know that the real rate signal coming from the money market is ominous when benchmarked against pre-recession norms.

 #Inflation #US2Y #moneymarket #realrates #Fed #recession #Bonds #Equities  #lasthurrah

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