Another Fed 75

The Fed announced another 0.75 percentage point (ppt) interest rate hike Wednesday, as widely expected, lifting the fed-funds target range to 2.25 – 2.50%. Stocks didn’t mind, with the S&P 500 rising after the announcement and finishing the day up 2.6%.^[i] Bond markets didn’t do a whole lot, with 10-year yields flattish at 2.79%, as we write, and 3-month yields down a whisker to 2.37%.^[ii] That shouldn’t shock, considering—as we showed last week—bond markets appeared to have priced this well-telegraphed move in advance. As ever, what matters is what happens from here, as the Fed is on the verge of inverting the yield curve—a matter worth watching, but not obsessing over.

Inversion isn’t guaranteed to happen, mind you, and it will probably rest on how markets interpret the Fed’s guidance. On that front, Fed head Jerome Powell wasn’t terribly helpful when addressing future moves at the post-meeting press conference. He told reporters a third 0.75 ppt hike in September could be warranted and that he sees the fed-funds range’s upper bound being between 3.0% and 3.5% by year end. But he also said the Fed couldn’t give “clear guidance” anymore and that future moves would be data-dependent. Soooooo. Seemingly clear guidance, alongside a disavowal of clear guidance. Try figuring that one out.

If recent history is a reliable guide, markets will spend the next several weeks trying to suss this out, parsing all Fedspeak and incoming data. Observers will likely hyperventilate over central bankers getting together at the Kansas City Fed’s annual big bash in Jackson Hole, Wyoming—this time centering on “Reassessing Constraints on the Economy and Policy.” So expect that now. If investors broadly expect the Fed to keep hiking, then 3-month yields will probably rise. If inflation expectations continue moderating, 10-year yields could continue their drift lower. We aren’t saying either is highly probable, mind you—we are just pointing out possibilities, specifically, the possibility of that 0.42 ppt gap between 3-month and 10-year yields closing.

This isn’t a solely American phenomenon. The UK yield curve inverted late last week, with 3-month yields there 0.079 ppt (or 7.9 basis points) above 10-year yields as of Tuesday’s close.^[iii] Continental European spreads, while wider than America’s, have slimmed lately. Barring a reversal in short or long rates’ recent path—which is possible—we could have a modestly inverted global yield curve soon enough.

In our view, that wouldn’t be an automatic trigger for anything. Given the glut of bank deposits in the US, banks are paying depositors far less than the fed-funds rate, so a government yield curve inversion probably wouldn’t break banks’ standard lending business models. Borrowing short and lending long would still be quite profitable. Plus, as we noted last week, there is enough difference among short (and long) rates among individual countries that plenty of cross-border arbitrage opportunities will probably exist. This can happen via banks or at the investor level, with entities borrowing at low long rates in Country A and investing in higher-yielding projects in Country B. Money always has ways of finding the highest-yielding asset.

So if the yield curve inverts in the US and/or globally, watch bank lending over the next few months. Watch investment measures like durable goods orders. But also watch sentiment, because the gap between expectations and reality is always the primary stock market driver. If inversion sends sentiment down anew and heightens recession fears, it could create a big, bullish gap between expectations and what is likely to unfold over the ensuing year or two. Said differently, if a messy yield curve drives expectations for a deep recession—but we get no recession or a shallow one—it could set stocks up very well indeed. Conversely, if inversion goes unnoticed and the downstream indicators of trouble look bleak, then it will probably be wise to square that up with what stocks are doing to assess whether markets have their heads in the clouds. That scenario doesn’t seem likely, based on how dim sentiment is right now, but we think it is important to consider all possibilities.

You will notice there is one thing we didn’t tell you to lean on: the Fed itself. Their forecasts aren’t worth the digital paper they are printed on. Even if Powell hadn’t told the world to basically tune him out, we would suggest not basing your interest rate and economic projections on Fed guidance. Monetary policymakers change their minds often. Forward guidance isn’t a concrete plan, but rather an exercise in ifs and all else equals. In our experience, the ifs are always iffy and all else is never equal, which is why we always encourage you, dear readers, not to try to predict Fed moves. Rather, be aware of the possibilities and prepare to weigh the potential risks and benefits of Fed decisions as they happen.