Rates Headed South for the Summer

May 19, 2019

The U.S. rate market is putting “paid” to the latest narrative on inflation as it continues to discount even deeper rate cuts despite new projections that trade tariffs will push consumer prices higher and spark inflationary pressures. Like at any point in the last several years, inflation always seems to be looming around the next corner. Yet it’s not and the Fed can’t figure out why. While the Fed watches and waits, unsure of their next move, the futures market is busy pricing in the possibility of three rate cuts by the end of next year (see chart below.) For those paying attention to price action rather than talking points, the message couldn’t be clearer: the threat of an intensifying global economic slowdown is a much bigger problem than any inflationary uptick.

The short term rate complex is probably the least speculative of any financial market. It’s the quiet man of markets, often dull and boring and largely overshadowed by the latest IPO or equities in general. But its message should never be ignored. Forward rate expectations are breaking down hard, pricing an aggressive reversal in Fed policy. Something is happening macro-economically, and not in a good way. The risk is that trade uncertainties have disrupted supply chains and capital investment more than we thought. And rather than being a temporary phenomenon, tariff regimes could become the new normal, with longer-term impact.

As I noted in “The Dollar and Deflation” and “Fed Resists Market Push for Rate Cuts” a sharp move up in the dollar is a strong and rising possibility as trade and political tensions consume major export-dependent regions abroad like China, Australia, UK, and Europe. The first line of defense for these countries is to offset the drop in activity by letting their currencies fall. All eyes are on the Chinese yuan in particular. A “source” on Friday claimed that China won’t let the currency weaken below 7.00 to the dollar. (See https://reut.rs/2YxkPp9 .) Believe that if you want to but central banks have a history of saying they won’t devalue their currencies, right up until the point that they do. I saw careers ruined in 1994 when Banxico (the Mexican central bank) devalued the peso just hours after insisting to the Street that they wouldn’t.

The rate market is sensing a dollar groundswell. Another leg up in the USD would be deflationary as well as destructive to dollar borrowers abroad. It’s hard to overstate the strength of this message. The dollar-inspired equity selloff of late 2018 might have been the warm-up act for what’s to come in 2019. The Fed and investors alike ignore this scenario at their peril because if this is how it plays out, inflation will be the least of their problems. Be long the dollar and bonds, preferably 2-3-year treasuries.