My baseline forecast has been that interest rates will stay “higher for longer.” Money markets are coming around to that view with interest rates now pricing in a 4.82% Fed Funds rate at year end, a sharp jump from 4.2% two weeks ago and 3.7% after the regional bank blowup. The two-year Treasury yield was back up to 4.31% yesterday as well, its highest level since March 10th.
The reason for this is probably not the debt-ceiling Kabuki playing out in Washington. While that is unsettling short term bond prices, money markets are reacting to sticky inflation. Core inflation hasn’t budged since January. Economist consensus forecasts see 5.3% year-over-year CPI inflation in June, far above the Fed’s 2% target. Corporate and real estate defaults are rising and S&P Global is now forecasting a 4.25% corporate default rate over the next 12 months, up from a 2.5% trailing rate at the end of the first quarter. The relatively low percentage disguises the large dollar amount involved since the market is so large. There is a lot of bad paper out there and a lot of debt that was incurred during the bubble (which was bigger in bonds than stocks) is going to be written off over the next few years. Corporate credit quality is steadily deteriorating with 29% of the Morningstar LSTA Leveraged Loan Index (which we should remember is filled with covenant-lite paper that doesn’t protect lenders) carries a B- rating. This shows that capital structures are remarkably weak when you consider this is the top, not the bottom, of the capital structure of the borrowers. The subordinated debt below the so-called bank debt is well into CCC territory which means it is garbage, not junk.”
“Higher for longer” spells serious trouble for credit markets priced off of unrealistic expectations that the Fed would keep rates artificially low forever while believing unbelievable Fed claims that inflation was too low. We are in the very early innings of the unwinding of the biggest credit bubble in history. The stock market is pretending this isn’t happening but stocks are the stupid stepchildren of markets. AI and the Metaverse aren’t going to save investors from the harsh reality of a debt-based economy.
The Fed is not discussing cutting rates. Instead, it is wrestling with whether to raise rates again in June or pause and see if previous hikes can push inflation closer to its 2% target. For the moment, inflation seems stalled out. The minutes of the Fed’s May meeting showed that the Fed is divided between hiking and pausing with no talk of cutting anytime soon. Interest rate futures priced in a 30% chance of a quarter point June hike after the May minutes were released and a nearly 55% chance of a quarter point hike in July. Put simply, things are moving in the wrong direction for those who were betting on rate cuts. As discussed above, those trades are now unwinding along with those parts of the credit market priced for lower for longer.
Legend:
"We are in the very early innings of the unwinding of the biggest credit bubble in history. The stock market is pretending this isn’t happening but stocks are the stupid stepchildren of markets. AI and the Metaverse aren’t going to save investors from the harsh reality of a debt-based economy."
I don't personally think the FED will raise rates again but of course the market might force that if they cant sell the treasuries needed to sustain government right?
Two or the three investment advisory services I subscribe to have been predicting a sharp fall in inflation starting in the June / July timeframe. They believe this will provide the cover for the FED to reduce rates by year end. The other advisory out firm are more in your camp except that they see a rising inflation rate catching everyone out by year end.
I return to the comment I made a few months ago that there is a huge amount of debt to be rolled by year end and that debt is going to cost (if it can be secured) several hundred basis points more that it was originally secured at unless rates fall sharply though additional liquidity provision by "someone". 2024 is looking like a turbulent year if we can even get past this Fall that is.