The Pivot Will Come; the Question Is When

I had a recent interview request, and one of the questions was where do I think the yield on the 10-year Treasury will be one year from now. As I thought about my answer, I couldn’t help but think, once again, that I would hate to have Jerome Powell’s job. There are just so many variables and so much uncertainty as to how inflation will play out, and on top of that he has to somehow appear apolitical (in an election year) in his deliberations. I guess it comes with the territory of being the world’s most powerful central banker. In any case, all I can do is offer my two cents on what I see coming. This advice along with $6 (previously $5) could get you a pumpkin spiced latte at Starbucks!

Following a huge spike from the low of 0.54% in mid-2020, the 10-year Treasury yield current sits at about 3.46% –very close to 11-year highs. This increase has profound implications for the economy because so many sectors of the economy have effectively reset to reflect very low interest rates. Nowhere is that more evident than in the housing sector. Housing prices have surged in recent years due, in large part, to super-low mortgage rates. But in very short order, the value proposition of owning a house has changed dramatically. The typical 30-year fixed-rate mortgage, which is used by most homeowners, is priced based (in part) on the 10-year Treasury yield. As the 10-year yield has spiked, mortgage rates have more than doubled to over 6%. That increase in borrowing costs, coupled with a huge spike in housing prices, has caused housing affordability to drop to its lowest level in decades. And the evidence is accumulating that unless interest rates stop rising, the effect on the industry at large will be staggering. 

I know what you’re thinking, and the answer is no. For many reasons (which I’ve covered in previous Market Commentaries), I don’t believe the damage to the housing sector will rise to anywhere near the catastrophic effects of the Great Financial Crisis. But I do think the interest-rate-induced damage to the housing sector, among other sectors, will be meaningful enough to force the Fed into a second major policy reversal in a short period of time. Many traders and other market participants had been expecting that this Fed “pivot” to interest-rate cuts (as opposed to rate hikes) would come sooner rather than later. However, cold water was thrown on those expectations on Tuesday when the August inflation report came in hotter than expected. Does that mean that the pivot will never come? No. It just means it’s been pushed out a bit. 

Now on to the answer to my interview question.

The most recent forecasts from the Federal Reserve (June) were calling for a 3.8% Fed Funds rate at the end of 2023, which was up from the prior estimate of 2.8% (March). However, since those projections were made public in June, the inflation problem has clearly broadened and deepened. As of right now, the Fed Funds futures are pricing in a target rate of about 4.2% a year from now. I would expect the Fed’s next round of projections will be increased closer to those market-based estimates. However, I would be very surprised if the Fed is able to raise short-term rates to those levels without causing a dramatic deterioration in key economic indicators, most notably those related to the housing market. True, the Fed will likely be highly reluctant to reverse course again until it becomes absolutely necessary. After all, they have their pride too. Given their recent, uh, miscalculations, the Fed is waiting for a broader deterioration in economic indicators before taking its foot off the gas. The problem with this approach is that the effects of interest rate hikes take time to filter through the economy. And so while we are seeing deterioration in some sectors, like housing, other sectors (read: consumer spending, which accounts for over two-thirds of GDP) have yet to deteriorate in any meaningful way. So as the Fed delays and delays, the economic damage wrought by rising interest rates will compound. Investors will soon recognize that, yet again, the Fed is late in changing its posture. Expectations for a recession will increase, putting downward pressure on longer-term interest rates even as the Fed keeps short-term rates elevated. 

Under the scenario I describe, I think it’s safe to assume that the yield curve will remain inverted to reflect an increasing likelihood of a recession, the severity of which will depend, in part, on how long it takes the Fed to respond to the weakening economic indicators. Judging by historical recessions, the spread between the 10-year Treasury and the Fed Funds target could become inverted to the tune of 100-200 basis points compared to the current spread of +0.30% (assumes a 0.75% hike in Fed Funds at next week’s meeting). If we further assume that the markets are correct and the Fed Funds target rises to 4.2% a year from now, that would put the 10-year yield at 100-200 basis points below that, or 2.2%-3.2%. So if I had to offer a single-point guess, I would take that midpoint and predict that the 10-year yield will be at 2.7% in a year. Of course, this all assumes that the Fed will not “pivot” by then, which I’ve already said is unlikely. So, back to square one!   

It’s easy to throw stones at the Fed. Their job is exceedingly difficult and fraught with peril. Still, I have to call ‘em as I see ‘em. The economy has simply become too dependent on low interest rates, and the housing sector is the “poster child” for that dependency. All this will get sorted out, but probably without minimizing the amount of damage. For now, we’ll remain cautious and defensive.