Recent signals of a resilient economy have led some to expect the Fed chief will hint about rates staying higher for longer. While Friday’s jobs data may loom larger for markets, some Powell-driven action definitely can’t be ruled out, hence largely flat stock action this morning.
No matter what the Fed chief has to say this week, the market has one idea stuck in its brain right now, and it’s all wrong, says our call of the day from volatility expert Harley Bassman.
“By intent or accident, the market has bet the ranch that the U.S. economy is going to ‘hard land’ soon, and thus induce the FED to cut rates as early as Labor Day
(September); that is simply NOT going to happen. While ‘goods’ inflation is
calming (used cars, really ?), ‘service’ inflation has not pulled back,” says Bassman, a managing partner at Simplify Asset Management, writing on his Convexity Maven blog post.
The money manager is best known for creating what’s now known as the ICE BofA MOVE Index — Wall Street’s most widely followed measure of fixed-income volatility.
Bassman lays out a simple reason as to why we won’t see a hard landing: “The demand for labor cannot be met as boomers retire from the workforce for reasons of either age or a (still) plump 401(k); and immigration (legal or otherwise) can no longer plug the gap. Every window I see has a ‘help wanted’ ad.”
Bassman says the Fed won’t cut rates until “sometime in 2024,” not in mid-2023.
The two-year bond yield is currently a whopping 4.888%, while the 10-year yield is at 3.953%.
Investors have been particularly rushing out of 10-year Treasurys bonds TMUBMUSD10Y,
“The ten-year is presently near 4.00% and using our simple bond math from discounting the yield curve, the two-year forward ten-year rate is 3.65%,” he said.
And based on his prediction that ten-year rates will drop to 3.50% if the Fed cuts rates to 2%, he sees little profit in buying 10-year bonds. “I see a lot of risk to make a 15bp gain (about 1 point in price).”
In short, Bassman said the yield curve is far too inverted even if inflation projections out there are optimistic relative to the Fed’s own politics and policies.
So what should investors do about Wall Street’s wrong-way bet? The money manager sees an opportunity via the current shape of the yield curve.
“If the peak FED rate is 5.1% to 5.4% (FED Dots), then that is the limit for the UST 2yr (since the 2yr only exceeds the FED rate in anticipation of continued rate hikes). Conversely, a rate reduction can certainly be much greater (50bp up vs 300bp down) offering an unbalanced return profile. This is the definition of positive convexity,” he said.
Bassman lays out his trade in the chart below, which suggests investors buy short-term Treasury futures:
“Traditionally, the main reason investors are willing to take a lower yield for a longer
maturity bond (yield curve inversion) is to pick up the greater duration, and thus
superior price performance if interest rates decline. Here this trade-off has been
curtailed via the use of listed CBOT futures contracts to gain leverage without the usual reduction in current yield,” said Bassman.
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Fed Chairman Powell’s semiannual report on monetary policy and the economy to the Senate Banking Committee kicks off at 10 a.m. and he will appear at the same time before the House Financial Services panel on Wednesday (follow live coverage here). Wholesale inventories are also due at 10 a.m., followed by consumer credit at 3 p.m.
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