Car rates

Preparing for the Fed’s Dovish pivot

In recent days, the chorus of Fed officials talking about “going neutral” reminded me of Yogi Berra’s famous saying: “If you don’t know where you’re going, you might end up somewhere else.” The current state of affairs is probably more about Alice in Wonderland author Lewis Carroll: “If you don’t know where you’re going, any road will get you there.” Flip-flopping and seemingly random decision-making under the guise of “data addiction” will inevitably lead us to high volatility and tail swings, especially since the Fed is no longer buying a massive amount of money. ‘assets. This place, a world of financial instability, is where this newfound love of “neutral” is leading us. And in due time, because that neutral point is so far away, this new mantra will likely encounter a dovish pivot to crush volatility and imbalanced markets. Investors should prepare for this pivot to happen sooner rather than later in my view.

Theoretically, the “neutral” rate is the rate at which the Fed’s policy stance is neither accommodative nor restrictive (the “real” version of the rate is called “r star” and is part of the famous Taylor rule which prescribes monetary policy taking into account economic potential, inflation and growth rates). It is the real short-term interest rate consistent with the economy maintaining full employment with associated price stability (see Kaplan, Dallas Fed here). However, the Fed really doesn’t know, and besides, nobody knows where we talk more and more about this mysterious “neutral” interest rate.

What the officials who designate the neutral rate are referring to is an imaginary, imaginary number, which reflects their own median forecast on the “points”. According to this consensus “model”, the current neutral rate is 2.4% (see here). This way of getting a believable (although most likely inaccurate) result is a great example of what Charles Seife calls “proof”. His book of the same name opens with this statement: “If you want to get people to believe something really, really stupid, stick a number on it.” Seife further calls these types of numbers “Potemkin” numbers, or fabricated statistics, digital facades that present themselves as real data, but just something that motivates the arguments one is trying to make. And it’s not the first time the Fed has come up with a number or a concept that justifies what it’s trying to do. I’m sure good unelected people have the best interests of the economy at heart, but since they don’t really have skin in the game like investors, they can basically make up terms and justifications as they go along. measure. And in the process create volatility, and dare I say, opportunity, for investors who can see the emperor naked.

The real problem with pinning a numerical value to a number like the neutral funds rate is that we’re in an environment the economy hasn’t seen in 50 years, and we’re dealing with the consequences of actions that are incredibly path dependent. The “equilibrium” concepts that result in the concept of neutral simply do not exist for an economy plagued by massive externalities like COVID, war, inflation, helicopter money, negative returns…the list goes on long.

Think of the brake pressure used to stop a car (again the car analogy was used by Kaplan, above, while Powell used the analogy of sailors sailing by the stars using his metaphor of the elusive star r nearly four years ago at the Jackson Hole symposium). When traveling on a flat surface, the average amount of brake pressure needed is quite predictable by solving simple physics equations. But when climbing and descending mountains that have never been driven on before, the average amount of brake pressure means very little, since the acceleration and deceleration required is highly dependent on the local gradient at that time. . A driver on flat terrain in the mountains inevitably ends up braking too hard on the slopes.

This is where the Fed is today. Their use of the term “going into neutral” means that they will likely become overly aggressive even if the economy slows. Real long-term interest rates measured by the 10-year TIP

S (Treasury Inflation Protected Securities is still negative (-0.10%), but the Fed holds a large portion of these TIPS.

The real yield, measured by the difference between nominal yields and headline inflation, is still the most negative in decades (the nominal 10-year Treasury is at 2.8% and inflation is around 8.5 % year-on-year, which makes the real ten-year yield shown in the chart below minus 6%!Source: Bloomberg), the neutral real is a long way off even if inflation moderates in the coming months. To recycle the quotes used above: “you can’t go from here without breaking something”!

Much of this predicament is because the Fed is so far behind the inflation problem (it literally stopped buying assets a month ago, long after everyone was shocked stickers at the grocery store and at the gas pump!). For a debt-ridden economy that isn’t quite ready for a sudden, sharp increase in interest rates, the most likely outcome is a sharper-than-expected slowdown if the Fed tries to stick to its target. to reach the “neutral” that it cannot foresee. With inflation already so high and consumers beginning to slow consumption, can rates get so high that it becomes even more difficult for consumers to consume? What if inflation doesn’t come down much as a result of the rate hike, but the economy, stock markets and confidence all crash in a self-fulfilling prophecy?

As I mentioned in my previous posts on this forum, we are now at a point where the short-term yield curve has already priced in multiple interest rate increases. The nominal two-year Treasury is at a yield of around 2.5% (Source: Bloomberg). With roll-down and carry, this could result in a total return of more than 3% for a year and with little risk to principal if held to maturity. Not bad considering the liquidity it provides on top of all that. What if the Fed is forced to turn to policy more easily than expected? Well, these short-term Treasuries could also see positive price gains.

As readers of my previous posts on this forum will know, I have been concerned about negative returns in bond markets for the past few years (see here). As rates rise and normality returns, we will begin to see good old bonds become attractive again as investments and hedges. We’re certainly not there yet, but since all good things start with the first leg, investors would be well served to consider dipping their toes into the short end of the US Treasury curve as we begin to prepare. to financial instability.