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December Is Not The 'Done Deal' The Market Thinks


We genuinely don't think the Fed is raising rates in December or next year, but we have been asked several times, "what if you are wrong?" Given how vocal certain members of the Fed have gotten, we know it is hard to stomach this phase of the roller coaster and we certainly don't blame anyone for feeling queasy. Listening to the mainstream media would imply that the Fed has made the decision already; but Fed Funds Futures are priced (as-of 11/10/2015) for only a 66% chance of the Fed raising to 0.25%-0.50% in December. It isn't the foregone conclusion you would think after watching CNBC. But, despite us making a social issue out of it, we don't rely on it. In other words, there isn't much risk to holding positions at the long-end of the yield curve whether they raise rates or not and here are the main reasons why.


First, in the low-inflation era we are in, and will likely be in for some time, the sensitivity of the world's borrowers (individuals, companies, governments) to changes in interest rates is much higher than it was back in the days of 3% and 4% inflation in the late 1980's and early 1990's. This is because interest payments, on a percentage basis, can more easily double or halve from 1% than from 5%. Said another way; the volatility of interest rates has some stasis throughout the continuum of what rates can be, but is not at all linearly correlated with how rate changes feel to a borrower. We don't think the Fed can raise back to the 4%, 5%, or 6% that many hope for (i.e., the globalized world is a persistent deflationary force because the supply of skilled emerging market labor rises every day.)

Secondly, by historical precedent, the Fed generally raises rates in a proper tightening cycle until market forces invert the yield curve (long rates lower than short rates). For example, the 30yr UST yield fell below the Fed Funds rate in 1989, 1998, 2000, and 2006-2007. Inverting the yield curve then gives the Fed cover to stop raising. With the current market's Fed raising ambitions to about 3% (see expectations chart above), we merely mention that the 30yr UST is already there (3.09% as-of 3:00pm ET 11/10/2015). If the Fed were to raise rates to say 3%, well the 30yr would probably be lower in yield then than it is now (see chart below) Any raising of rates by the Fed in this 1.3% inflation world, would tend to lower inflation further and raise the unemployment rate higher. Is there really a party that needs sobering? 



We want to repeat that we do not think the Fed will have enough time of relative solace to raise even once before a global slowdown/recession is obvious in the U.S. (see our last piece). In our expectation, we think the yield curve will bullishly flatten (i.e., long-term rates falling down nearer to the Fed Funds rate at 0%). Yet, we recognize the value in exploring what would happen if we are wrong. We think that the more hawkish the Fed is (even raising rates once or twice), the more it ensures a US recession, but it seems like an awful lot of global pain that could be avoided.