Aggressive Tightening in a Late Cycle Bond Market

There are lots of ways to animate the extreme level of accommodation among most global central banks. A host of Fed speakers have been doing so in real terms, that is the real cost of credit relative to inflation and it is used as a tool to shape expectations for the heavy lift ahead. The chart shows real fed funds against the shape of the yield curve. It demonstrates how unusual a place the Fed and other central banks find themselves.

Over time we see that a flattening yield signals lower growth and higher recession risks which in turn prompts more monetary accommodation. The real policy rate goes lower, the economy gets needed stimulus, and the yield curve begins to steepen on the good news. When the economy runs hot the opposite string of adjustments occur.

Today the real policy rate is at historic extremes and is why the Fed has been so doggedly hawkish signaling several hundred basis points in rate hikes. The challenge will be following through on that intent without slowing growth so much the economy falls into recession. The Paul Volker Fed used recession to curb inflation in the 1980’s. Will the Powell Fed do the same? The bond market is already suggesting a material risk of failure and we are just getting started. While bond market signals are arguable less robust than they were owing to years of quantitative easing, at face value it is at levels consistent with a Fed loosening policy, not removing accommodation. It is also emblematic of the unique inflation challenge facing central banks today.   

Slowing economic growth to lower inflation will not be collateral damage to this new policy regime, it will be the primary intent. That is less a forecast then a recognition that growth must slow significantly to fight inflation that has many nefarious roots, some demand side related and many supply side related. Achieving that balance is difficult for many reasons not the least of which is that policy adjustments affect the real economy with significant lags. It is why monetary policy is as much art as it is dismal science.  

It also means corporate earnings expectations will come under increasing pressure over coming months and at a time when multiple compression is already driving a fresh valuation adjustment.


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