Submitted by Kevin Muir of The Macro Tourist
First up - sorry for the lack of posts recently. I have some excuses, but they aren’t good ones, so I will spare you the details.
Even though lately I haven’t been following the markets as much as I would like, I can’t help but chirp in regarding market action.
Recently, it has become popular to believe the Fed has hiked into the next recession. I am seeing this idea repeated throughout my ‘fast money’ crowd feed.
Last week, Alex Gurevich tweeted a comment, that on top of being rather witty, also perfectly epitomizes this thinking.
Now I doubt Alex thinks the last rate hike is behind us - after all, the front end of the curve has at least a couple of hikes priced in between now and year-end. Yet, more and more market participants are discounting the Fed moving to neutral much sooner than was previously the case.
The 3-month Eurodollar futures curve (which represents the rate at which banks lend USD to one another) has flattened to the point where the March 2020 contract is trading at a slightly higher yield than all the contracts out to September 2022.
This flattening of the Eurodollar curve is signifying that market participants most likely believe the Federal Reserve is two or three hikes away from finishing their rate tightening.
Now, markets get it wrong all the time - so don’t assume this will definitely occur.
What I wanted to point out is that the consensus believes this to be the path of short-term interest rates.
Perceptions change all time. Six months ago, the market had assumed there would be 35 basis points of tightening in the two year period between March 2020 and March 2022.
Yet today that spread has collapsed.
I don’t know if the market is now correct, or if it was more right last year. All I can do is observe how the market is interpreting developments and give my two cents.
And when it comes to the increasingly celebrated belief that the Federal Reserve has tightened into the next recession, I think the market is confusing the financial economy with the real economy.
The financial economy is precariously perched on a peak of financial asset price perfection. I have little doubt the Federal Reserve’s tightening campaign will cause a slowdown in financial asset appreciation. For the first time in a long while, forward rates for 3-month Eurodollar deposits of 3% will offer a compelling alternative for those willing to sit in cash equivalents.
Yet this doesn’t necessarily mean the real economy will suffer. The reality is that financial assets are up on a stick from the decade-long global quantitative easing program. Investors have been chased out the risk and credit curves, with those asset prices rising much more than what can be attributed to improvements in fundamental underlying economic prospects.
As liquidity is withdrawn, although financial markets will suffer, the economy might prove much more resilient than most market pundits anticipate. After all, easing through liquidity injections was far less effective at stimulating the real economy than most economists forecasted. Why can’t tightening through liquidity withdrawal be far less worrisome than these same economists fear? I am much more worried about financial asset prices than I am about the real economy…