Market to Fed: two rate cuts needed

We're in the midst of a mini-replay of the drama surrounding Fed policy that played out late last year and early this year. Back then the market was telling the Fed that it was mistaken in planning two more rate hikes this year, but it took the Fed a bit too long to figure that out, and that in turn led to a severe equity market selloff. But in the end they did figure it out, and they apologized to boot. Now the bond market is telling the Fed that at least two rate cuts are needed. They are needed to offset the increased uncertainties surrounding Trump's trade/tariff wars, which have now expanded to include Mexico, and the general malaise which has kept economy's growth potential from being fully realized.

Higher tariffs reduce future economic growth expectations and increase general uncertainty (e.g., what if tariff wars escalate further? what if China stumbles and brings down the rest of the world with it?). If the Fed fails to offset the increased demand for money this creates, then deflationary forces will take root and the risk of a recession (though still very low in my estimation) will increase.

Chart #1 

Chart #2 

In Chart #1 we see the significant decline in both nominal and real yields that has occurred since their November '18 peak. 5-yr Treasury yields have fallen over 100 bps, from 3.1% to 1.96%. 5-yr TIPS real yields have fallen by 80 bps, from 1.16% to 0.36%. Inflation expectations are down to 1.6%, but that could be largely due to the recent decline in oil prices, as shown in Chart #2.

Chart #3

Chart #3 compares the current real Fed funds rate (blue line: the difference between the Fed's target funds rate and the year over year change in the PCE Core inflation rate) with the market's expectation of what that real rate will average over the next 5 years (red line: the real yield on 5-yr TIPS). The message here is that the front end of the real yield curve is inverted, and that is a sure sign that monetary policy as it stands today is a bit too tight. Whereas the Fed says it is likely to stand pat for the foreseeable future, the market is saying they need to cut the funds rate target to 2% (vs the current 2.5%), and hold it there for the foreseeable future. The last two recessions were preceded by a similar inversion of the real yield curve (i.e., the blue line exceeding the red line), but the one important difference between now and the last two recessions is that real rates were much higher then than they are now. Red lights are flashing today, but this is not a four-alarm fire; it's more like the need for some modest adjustment to policy.

Chart #4

Chart #4 is the best chart to illustrate the impact of monetary policy on the economy. It combines the real Fed funds rate (blue line: the true "cost" of borrowing money) with the slope of the Treasury yield curve (red line: the difference between 1- and 10-yr Treasury yields). When the yield curve is flat or inverted and real interest rates are high, a recession has always followed. Today the yield curve is flat, but real interest rates are still relatively low. The current situation is problematic, but a recession is not imminent or foreordained. 

Chart #5 

Chart #5 is the classic way to look at the shape of the nominal Treasury yield curve, as measured by the difference between 2- and 10-yr Treasury yields. Here we see that the nominal curve is still somewhat positively-sloped. Again, a recession is not foreordained nor imminent. The market is sending a strong message to the Fed, and the market is betting that the Fed will respond accordingly.

Chart #6

If the Fed were really, really "tight," we would be seeing swap spreads rise, which would be an indication that liquidity conditions were deteriorating. Instead, we see swap spreads falling (see Chart #6). I interpret this to mean that the market is buying swap spreads in addition to Treasuries (pushing both yields down), in an attempt to hedge against the risks posed by Trump's tariff wars. We saw the same action in late 2015, when real GDP growth fell almost to zero. (That was also the time when oil prices collapsed from $100/bbl to $30/bbl, creating shock waves throughout the oil industry that threatened to spread to the rest of the economy.) The Fed is not really "tight" today, since they are not trying to restrict liquidity; they are simply keeping short rates a bit too high. The fundamentals of the economy are still sound, but the market is worried and so the market is paying up for bond-market hedges like swaps and bonds.

Chart #7

Chart #7 tells the same story. Credit Default Swap spreads have moved up a bit, but they are still relatively low. The market is only marginally concerned about the outlook for corporate profits. We're talking about a slowdown in growth, not a recession.

Chart #8

Chart #8 shows the market's expectation for what the Fed's target funds rate will be by the end of this year (as derived from Fed funds futures). From its high point of 2.93% last November (which implied two tightenings), the market now sees the funds rate target falling to 2% (which implies two easings). If the Fed doesn't get this message and act on it soon, then we might expect problems.

Chart #9

Finally, Chart #9 shows how the equity market is dealing with these issues. Fears (as measured by implied equity option volatility, or the Vix index) are up and growth expectations (as measured by the 10-yr Treasury yield) are down, which adds up to a moderate spike in the Vix/10-yr ratio. Equity prices have responded by falling, as they have during past "worry" episodes. The current episode is not yet of the significant variety, however. The Fed still has some time to react, but they shouldn't delay too long.