It’s been a doozy of a few months for the bond markets as 10 year interest rates surged from 4% during the Summer to over 5% in October and then round tripped all the way back. Two months ago when the rate was over 5% there was constant chatter of a resurgence in inflation and a lack of demand for new bond issuance. But in the last six weeks interest rates have plummeted on expectations of lower inflation and an easier Federal Reserve in 2024. It all begs the question – was 5% the peak?1
You can probably guess my answer. It’s a resounding YES. In fact, I don’t think rates ever should have gotten to 5%. I think the Fed reacted too late in 2021 and then raised rates faster than they should have which has resulted in a lot more interest rate volatility than we should have experienced. But you can’t blame the Fed for the 10 year moving to 5%. After all, they chose to let the 10 year rate wander and they let the dog off the leash a bit much. But boy did they rein him in this week. Rates fell 0.3% following the FOMC decision on Wednesday alone. It was a stunning surprise as the Fed explicitly stated that their goal is to cut rates 3 times in 2024 and an additional 4 times in 2025.
This is a side note, but this is a big victory for systematic investing processes. 6 weeks ago we issued a strategic update in which we said we were extending bond duration with rates at 5%. We also said that, behaviorally, this felt very uncomfortable. But systematically, it’s what the rules said to do. So we did it. And whether that’s lucky or good is yet to be seen (so far very good), but it’s evidence that systematic beats strategies that rely on gut instinct because gut instincts are too emotional at the times when it looks like the market is right for overreacting.
The response to the decision was very bullish both for bonds and stocks. But it also raises another interesting question – is this an Arthur Burns moment? That, of course, refers to the 1970s and the Burns Fed which eased policy after a hint of falling inflation which then contributed to a resurgence in inflation above previous levels. As I’ve noted on several occasions, this environment never looked like the 1970s to me and so the Arthur Burns comparison starts with a false comparison. But could the Fed be at risk of contributing to higher future inflation and having to backpedal on the recent comments? I don’t think so. The reason why is because we’ve already noted that inflation likely peaked long ago and policy, while perhaps easing, is still sufficiently tight to reduce aggregate demand.
The last few years have felt like a lifetime, but it’s interesting to think that Fed policy was viewed as highly restrictive at the beginning of 2023 with 10 year rates at 3.8%. And today, with rates at 3.9% they’re viewed as easing simply because, for a brief moment, rates were at 5%. But more importantly, it’s still interesting to note that the policy rate only became highly restrictive in Q2 of this year when real rates went negative. The entirety of the 2022 rate hikes was the Fed playing catch up gradually tightening the economy. So policy is still tight and even if the Fed cuts rates to the high 4% range that will still be restrictive. That’s especially true when you consider that disinflation is likely entrenched which means real rates could be even lower in 2024 as demand eases and inflation drops to the 2.5% range.
And I guess that’s actually the most important question in all of this – has inflation peaked? Again, I’d say resoundingly, YES. We predicted that inflation had peaked back in January 2022 which just so happened to be 2 months ahead of the peak in core PCE. And even though we got it dead right directionally, it’s lingered longer than I expected. And I would expect that lag to continue. The key there is that shelter is still massively overstated in the CPI and PCE. We know rental prices are negative yet the CPI shows shelter at 6.5%. There’s no question that that will continue to adjust so you have a huge disinflationary headwind for the broader index and assuming no unusual outliers that shelter component alone will drive inflation back to target. So yes, inflation has peaked, but the road to 2-2.5% is still going to take time. By our estimates we are unlikely to get to the Fed’s 2% target until late 2024 and possibly early 2025. So interest rates should remain somewhat volatile (though headed on a sideways to downward trajectory) as the coming year plays out.
To sum it all up:
- Has inflation peaked. YES. It peaked long ago and disinflation is very likely entrenched until shelter inflation adjusts further to catch up with what we’re seeing with real-time rental prices.
- Is this an Arthur Burns moment? NO. The Fed has played this nicely so far. Better than I expected. And even if they start cutting in 2024 policy will still remain restrictive.
- Have interest rates peaked? YES. 5% on the 10 year was likely the peak for this cycle assuming inflation isn’t entrenched and the Fed maintains a restrictive policy stance that will continue to pressure aggregate demand.
Footnote 1 – I’ve never really understood the bond supply thinking. It’s basically old school “bond vigilante” analysis which assumes that the market controls rates and not the Fed. But the supply of bonds doesn’t set the policy rate. The supply of bonds could impact the rate of inflation, which could result in the Fed raising rates, but the price of bonds isn’t controlled by the market. The price of bonds is almost entirely a function of future Fed policy. So, as the dog walking analogy holds, it sometimes looks like the dog is walking the man, but the Fed is a dog walker with a monopoly on reserve power and they can pin interest rates wherever they want to. Smart bond traders know this. They know that if the Fed wanted to set the 10 year interest rate at 0% they’d simply have to say so. If they want to rein that dog in and hold it at the neck there’s nothing stopping them from doing that. Heck, the US Treasury doesn’t even need to issue a 10 year bond. They could just print the cash if they really wanted to and set the interest rate at 0% in perpetuity. They’re the only entity in the economy that could just issue 0% yielding cash and people would still happily scoop it up. But the point is, if inflation is falling (as it is today) and the supply of bonds is rising then the bond issuance must not be a primary causal inflation factor. Which would mean that interest rates will follow expected inflation, not expected new supply. And while new supply could impact inflation, one of the big lessons from the last 40 years is that government bond supply can explode higher and inflation can still move lower (because outside of unusual environments like Covid, other factors drive inflation more so than government money printing).