Trading Desk: Rate Relief

Investors who were once running scared from the biggest interest rate hike in a generation have apparently found some measure of comfort here, with the S&P 500 is down only 1% and the supposedly rate-sensitive NASDAQ is practically unchanged.

But nobody’s talking about why. The stock market has been trained to take its cues from the bond market. And bonds have registered absolutely zero surprise.

The day before last week’s Fed decision, 10-year Treasury yields had surged to 3.49% while other points of the yield curve were once again flashing a recession warning. Today, that same long-term rate closed at 3.15% . . . reverting to where it was nearly two weeks ago.

The Fed made its big move. And almost across the board, bond yields went down. Evidently¬† too much “shock and awe” was circulating on this end of Wall Street, pushing yields even higher than what the Fed had in mind.

That’s a good thing. If you’re looking for a sense of how bad the bond market thinks it will get, just go back to last Tuesday and see.

And because bonds anticipate the future of interest rates, last Tuesday’s yield curve probably reflects the rest of the Fed’s tightening cycle as well. Six months from now, the Fed itself thinks overnight rates will climb another 1.75 percentage point . . . rate futures traders agree.

The market is betting that there’s even a 66% chance that the Fed will need to raise the short end of the curve at least a full 2 points between now and the end of the year. In that scenario, we’ll see lending rates back where they were in 2005 by December.

But from there, the Fed projects another 0.50 percentage point of hikes in 2023 before it’s time to relax. That’s what about a quarter of the people in the market already think we’ll get in the next six months.

Maybe they’re right. Maybe the Fed will need to get extremely aggressive to get inflation back in the box. However, even that scenario takes rates back to October 2005 levels. The housing market didn’t crash for another 2-3 years.

And if the Fed feels a crash coming, you can bet future rate hikes get put on hold extremely quickly. I think that’s what’s going on in the bond market now . . . we all knew rates were going up, but only the timing has accelerated a little.

So far, we can handle it. The “scary” part of the yield curve has healed a little. Going five years out, interest rates are once again laddered as they should be to reflect a normal economic environment, with lower rates at the short end rising as you advance the calendar.

Admittedly, yields are still muddled beyond the five-year point, which raises the question of whether a recession is coming somewhere in the 2026-7 timeline . . . but that’s a long, long way from fretting about an instant crash around the corner.

Bond investors are relatively sanguine. Rates are lining up the way they should. If anything, the long end is probably digesting distortions from the Fed’s rolling exit from its own bloated balance sheet.

Sooner or later, longer-dated bonds on that balance sheet will mature. But we really won’t hit that point for at least another year. That’s a long time away.

And as I keep saying, fleeing the market today ahead of a recession that might be a year or more away only makes sense if you’re a diehard buy-and-hold-forever investor. If you have more of a trading mentality, it’s just another season full of opportunities.