TL; DR:

Last Friday, interest rate traders in the U.S. were assigning a 2.9% chance of a rate hike in December, with 0% chance of a rate cut.
But that was an about face from the previous day when they were assigning a 1.4% chance of a cut and 0% chance of a hike.
Why the big swing? In between those readings, the U.S. Bureau of Labour Statistics announced a surprising drop in the unemployment rate from 3.9% to 3.7%.
Yields on 10-year Treasuries rose to nearly 4.25% as some participants reassessed the surprising strength in payrolls to mean ‘no December cut’.
Risk markets are still expecting cuts in 2024, but even then, lower interest rates in the short term may lead to higher rates in the long term.
Why? Because if the reason for rate cuts is a collapse in growth/recession or a systemic breakage, then increasing treasury issuance to gap over lost tax receipts and higher debt and deficits will be required, and that will require higher yields to support the issuance and cap/anchor inflation.
The not so good news is that the bad news is going to have to be pretty bad to see the sort of pivot, cut and stimulus that seems to have already been priced into equities and bond markets.
Conclusion? Markets are still fading (not listening to) the hawk (the Fed), but have you considered how your business, treasury and investments are positioned if the market is wrong?

U.S. unemployment in November surprised to the downside

As of 10.30am on Friday 8 December market pricing for 30-day Fed Funds futures indicated a 97.1% probability of the Fed leaving the Federal Funds Rate at 5.25% to 5.50% when it meets on Wednesday (tomorrow).

And there was a 2.9% implied probability of a 25-basis point rate hike but 0% probability of a cut.

This was a change from the day before when markets were pricing in a 1.4% probability of a 25-basis point rate cut (with a 98.6% probability of a pause).

Why this 4.3% swing (on the margins) from cut to hike?

Well, 2 hours before (at 8.30am), the U.S. Bureau of Labour Statistics announced a surprise drop in the unemployment rate from 3.9% in October to 3.7%. This was also lower than the September print of 3.8%.

As we know, the Fed wants inflation to return to its 2% target rate. It’s not there yet. It’s taking longer than expected and markets are getting impatient. Wages are growing. Unemployment is extremely low and there are no signs of it materially increasing.

Hmmm?

But to get where the Fed wants to be, jobs will need to be lost in order to slay disposable income and reduce the still high levels of aggregate demand (that the Fed has been intentionally destroying through its rate cuts) so that inflation can completely roll over and stay anchored sustainably, i.e., at least a few good months of evidence.

So, to see employment increasing (instead of decreasing) will frustrate the Fed and not support any easing. Payrolls and jobs are still way too strong.

This explains why 10-year Treasury yields rose, and why equities rallied which in turn probably puts more pressure on the Fed to wrap equity bulls over the knuckles at the next FOMC meeting.

It wasn’t a massive move because 98.6%, or nearly the entire market was focused on a pause.

Maybe a pause with some tougher guidance at the press conference might be what’s needed?

Still, all eyes are now on Wednesday’s interest rate policy decision as well as the Fed’s latest set of economic projections. There’s unlikely to be any effect on the balance sheet run-off which now sits at $7.7 trillion. Liquidity is still overly abundant.

But there are bigger considerations to think about.

And that’s where we return to the topic of today’s note, which is to say that lower interest rates in the short term can lead to higher interest rates in the long term if rates are cut too soon in the face of economic conditions that are simply not bad enough to warrant the big cuts that seem to have already been priced into equities and the bond trade that seems to be back.

Implications for the Fed and markets

I’ve written before that for the Fed to really pivot in line with various bullish market narratives that suggest 125 basis points of rate cuts next year and much more later will require a precipitous hard landing.

I’ve suggested that this, if it happens, might either be caused by: (a) bank failures or some other plumbing or systemic breakage that would recreate a GFC and cost of capital reset to forgive debt; or (b) a deep recession.

In the meantime, we’ve been in a ‘no landing’ and risk markets have been allowed to sail further and higher on future growth expectations and animal spirits.

And because option (a) would in many cases lead to a recession, it probably means option (b) is the one worth thinking about.

So, what’s the market’s narrative around the Fed’s recession playbook?

That’s simple. Rate cuts beginning with 125 basis points early next year, fiscal stimulus from Treasury, and to fund that stimulus Treasuries issued at lower managed yields, bond prices go up and equities go up because they price in the future effect of lower rates, and the USD weakens a little but doesn’t crash because as the world reserve currency and the key denominator of debt there is a level of natural demand for the greenback. And then perhaps more Fed note/bond buying if required, i.e., QE Infinity never went away.

But is that all there is to it?

Nope. Even though that first order narrative has been fuelling equities for some time (despite higher money market rates and bond yields) it’s simply the first iteration of what happens if the U.S. were to go into recession.

Firstly, what creates the business cycle is central banks. In this case, the cycle would be brought to an end by higher rates for too long.

Secondly, recessions lead to lower savings, productivity and declining growth, and sooner or later people are laid off/unemployment increases, corporate profits decrease and tax revenues to government get flushed down the dunny.

We’re not there yet, but if we were to get there the main methods for government to replace lost tax receipts (when productivity is in decline) include increasing the tax rate or stopping government spending. And given neither of those remedies would be popular in an election year with job losses, the answer must be that Treasury issues more debt to cover the gap.

First to make up for a loss in government tax income and then to cover the expanding deficit and the rising interest cost on the debt, and then to refinance around $8 trillion of the government’s $33.7 trillion of debt at interest rates that are 400 basis point higher than they were during the last refinancing cycle. So, call that $11 trillion or 1/3rd of the debt stack.

But on top of that, issuance would have to increase to accommodate more fiscal spending required under Biden’s suite of fiscal policies; including spending to increase critical minerals security, capex required for just-in-case regionalisation and friend shoring (e.g., semis, ag, energy), increases in defence spending to respond to deteriorating geopolitics, and funding to maintain capex for old infrastructure and retooling for the energy transition. And what if oil/LNG spikes again?

The result? Inflation is unlikely to run as low as the Fed’s targeted 2%.

Even if we assume without going too crazy that U.S. inflation settles around 2.5% to 3%, the Fed will need to keep the FFR above this to keep inflation subdued and to create a real rate of return. And on that last point, the Fed has made it clear that it wants at least a 0.5% real rate.

Assuming all the above to remain the case, we can easily imagine a longer term Federal Funds Rate (dare I say neutral rate) of ~3.5% if not higher.

And that’s one possible scenario when lower rates (arising from rate cuts in response to breakages/recession) can lead to higher rates to make debt issuance attractive to investors and cap inflationary pressures.

Where to from here in the U.S. and Australia?

U.S.

We wait to see what happens on Wednesday night but more importantly we watch the data on inflation and unemployment - and particularly unemployment because it’s the final hammer of the nail that spells when the Fed might be done.

And here in Australia?

If yields on Treasuries fall and Australian official rates stay where they are, the AUD strengthens against the USD and less inflation is imported through imports, but we receive less back for our US denominated exports. The negative carry with the U.S. becomes less negative even if the RBA remains on pause.
If yields on Treasuries move higher for longer and potentially increase, the USD stays stronger against the AUD (if all other things including a stagnant China remain equal), we import more inflation which effects more people, and we receive more dollars back for our USD denominated exports which effects less people, although the prices per tonne, kg, pound and ounce will be lower given commodity prices tend to fall as the USD strengthens. And the negative carry with the U.S. widens if the RBA remains on pause.

I would explain my 2024 outlook like this

If subsequent news on unemployment (and inflation) is too good to be bad, then it’s bad news for a pivot/major rate cuts and stimulus, but we stay coasting on volatile thermals with a ‘no landing,’ which might be the best news we can hope for unless we get bad news that’s so bad that it smashes corporate earnings, tax receipts, household disposable incomes and requires a deep Fed pivot and Treasury issuance/helicopter money to kickstart the economy; but if we only get lukewarm bad news that’s irritating but not bad enough and aggregate demand is still high, then the Pivot’s off the table and the good news of lower interest rates and higher equities/bond prices will be short-lived as low rates give way to still higher rates for longer to anchor Treasury issuance and inflation to refinance the bill for the GFC rate reset party that went on too long, and to avoid a sovereign default.

Phew!

The bottom line

The bad news is going to have to be pretty bloody bad to see the sort of pivot, cut and stimulus that equity valuations and the reawakened bond trade seem to have already factored in. Markets are still fading (not listening to) the hawk (the Fed). But what if markets are wrong? Will there be another round of bond carnage? How are you positioned in your business, treasury and investments if the market is wrong?

And if the market is right, see you on those endless thermals!?

Mike

When lower rates can lead to higher rates