This and the following week are heavily influenced by typical summer trading patterns, characterized by reduced volume and unpredictable market movements. Interestingly, even with a favorable CPI report last week, interest rates are at their peak for the year. This begs the question: what truly influences rates nowadays? We thought it was inflation, but the current scenario suggests otherwise.
Several factors are currently shaping the market, some of which loop back to inflation. For example, the term “no landing” is gaining traction, replacing the previously popular “soft landing” in discussions about post-pandemic economic growth.
- The “No Landing” Perspective Previously, there was a belief that the Federal Reserve’s stringent policies would impact economic performance, making it challenging for the Fed to achieve a balance between curbing inflation and preventing significant economic harm. However, nearly two years into one of the most assertive rate increase phases, job growth metrics have only recently returned to what we’d call “exceptionally robust” compared to earlier economic growth phases. While not all indicators are positive, the record low unemployment rates combined with significant job growth suggest economic tenacity, at least for the time being. If the “no landing” theory holds, it might mean less deflationary pressure. The recent rise in fuel costs supports this view. Some experts believe the last couple of months’ dip in inflation is a short-lived adjustment from an exaggerated fuel price surge. They argue that the current price hikes are more stable, especially in a “no landing” context, and persistent high energy costs could keep yearly inflation above 2%.
- The Basics of Supply and Demand This is predominantly about supply. The government’s expenditure exceeds last year’s, and its revenue is lower than the previous year. Additionally, the government is servicing its debt at historically high interest rates. This scenario suggests an increase in Treasury issuance, evident from the latest refunding news. While Fitch’s rating downgrade played a minor role, it’s still worth noting.
- The Fed’s Transition from “Discovering” to “Maintaining” a Rate Cap The Federal Reserve seems to have identified the maximum rate for this cycle, though they could still increase rates if data suggests so. While this might appear beneficial for rates, it’s primarily advantageous for the yield curve. Short-term rates have prospered at the cost of long-term rates. If the Fed doesn’t foresee further hikes, short-term rates won’t need to rise. Hence, any shifts in trading due to economic conditions or the Fed’s projections are more evident in the longer yield curve segment. This phenomenon is the “bear steepening” everyone’s discussing.
So, What’s the Takeaway? For long-term rates to decrease, short-term rates must first drop. These short-term rates hinge on the Fed’s predictions about how long the current rate will remain. If the economy shrinks and inflation stays around 2% annually, the Fed might soon hint at potential rate reductions. The short-term rates would react, and the long-term rates would likely follow, albeit at a slower pace.
The interplay between fuel prices and economic growth indicates that both need to stabilize before we witness significant rate relief. These factors also influence the Fed’s rate projections.
Addressing the Treasury’s supply challenge is complex. Conversations about urging the U.S. government to either reduce expenditure or boost revenue might seem far-fetched, irrespective of political affiliations.