Treasury yields are on the march higher. Indeed, the move to multi-decade highs in the 10-year Treasury Note yield has been the primary (but not only) reason stocks have declined over the past several weeks. Now, one of the reasons yields have risen is because investors have been “pushing out” the date of expected rate cuts, as investors begin to accept the Fed may keep rates “higher for longer.” That idea was furthered over the weekend in an article by “Fed Whisperer” Nick Timiraos of the Wall Street Journal, and that article was responsible for the rise in yields on Monday.
In Tuesday’s issue of my daily market briefing, Eagle Eye Opener (which you simply must subscribe to, if you want to know what real professionals are watching each trading day), we explained that there’s usually always one Fed Whisperer at the Wall Street Journal, and currently it’s Timiraos. Prior to Timiraos, the Fed Whisperer was Jon Hilsenrath.
The fact that these Fed reporters have deep insight into what the Fed may do is not a coincidence, because the Fed does not like to surprise markets anymore, so the more it can telegraph its decisions and communications, theoretically, the smoother the digestion of that news by stock and bond markets. Point being, whether official or unofficial, the Fed tends to “tip off” the current WSJ Fed reporter to any policy shifts or changes so that it can be disseminated in the markets and not surprise investors.
It’s for that reason that an article from Timiraos this weekend caught the market’s collective attention. The focus of the article was on an economic statistic called “r-star” or sometimes “r*”, but if we read between the lines of the econ speak, the message was clear: The chances the Fed hikes again and/or keeps rates higher for longer may be higher than the market currently appreciates, and if that’s true, it’ll add another headwind for stocks because it’ll damage one of the three pillars of the rally (i.e., the assumption the Fed is done or almost done).
What did Timiraos say? Essentially, Timiraos said that there’s a growing feeling among Fed members that the neutral real interest rate is higher than currently thought. The neutral real interest rate, which is r*, is the level of real interest rates (so nominal fed funds minus expectations for inflation over the next year) that is neither a tailwind nor a headwind on economic growth (so it’s neutral).
Why does this matter? In eras of high inflation, such as now, the Fed wants to get real interest rates into “restrictive” territory, so that economic growth and inflation both slow. But what is “restrictive?” Well, restrictive depends on where Fed officials think the neutral real rate is. Consider that for the last several years, Fed consensus has been that the neutral real rate was 0.5% (so, fed funds 0.5% above one-year inflation expectations). With longer-run annual inflation expectations still around 2-3% and fed funds at 5.375%, right now, real rates are clearly above neutral (2.5-3.5%, depending on how you calculate forward inflation). If the neutral real rate is still 0.5%, then that means real rates are 2-3% above neutral and are putting a serious headwind on growth.
But what if the neutral rate isn’t 0.5% anymore? What if it’s 1.5% or 2.0%?
If that’s the case, then real interest rates aren’t as restrictive as we thought they were, and as a result, rate hikes won’t slow the economy nor blunt inflation as much as the Fed would expect. The net result isn’t so much that the Fed will keep raising rates, but instead that the Fed will keep rates higher for longer, because they aren’t as much of a headwind on growth as was previously expected. That’s why the neutral rate matters and why yields rose after the Timiraos article.
What Comes Next? This debate about the level of r* (or the neutral real interest rate) has been ongoing for months, and there are camps in the Fed that think it’s higher than 0.5% and camps in the Fed that think it is still 0.5%. The reason this article caught everyone’s attention is because Timiraos wrote it a few days before Federal Reserve Chairman Jerome Powell speaks at the Jackson Hole Summitt on Friday, and there’s some concern that this article could be softening up the market for Powell to deliver a hawkish message that drives home the higher-for-longer message to markets. If that’s the case, expect more volatility in stocks and bonds.
Bottom line, higher for longer is a risk to this rally, because it’s not the height of rates that matters as much as how long they stay high, so we’ll continue to monitor the debate over r* in the coming weeks. But in the more immediate term, if we see Powell hint at higher for longer on Friday, we will need to brace for more equity market volatility, with defensive sectors (utilities, healthcare, staples) likely relatively outperforming (as they have since this pullback started).
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On Seeing the Beauty
“Anyone who keeps the ability to see beauty never grows old.”
— Franz Kafka
What does the world look like? Well, it depends on your eyes. If you train your perception on the sublime, that’s what you’re going to see. This is especially true as we advance in age, because the path to the end is, unfortunately, filled with sadness, loss of friends, health issues and the realization of life’s finality. Yet, if we can keep our ability to see the beauty of the world, as Kafka says, we will never grow old.
Wisdom about money, investing and life can be found anywhere. If you have a good quote that you’d like me to share with your fellow readers, send it to me, along with any comments, questions and suggestions you have about my newsletters, seminars or anything else. Click here to ask Jim.
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In the name of the best within us,
Jim Woods
