Alpha Report: The Fed, The Credit Cycle, and the risk of inaction

Cutting or hiking cycle?

Main Idea:

In this report, I want to cover two points contextualizing WHERE we are in the macro cycle and explain HOW these falsify several consensus views about what should happen in the next 2 months.

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Point #1:

We remain in a regime where the Fed is clearly allowing cuts to be priced on the forward curve. This is what many economists would call a “cutting cycle.” While this is true, the entire question in a cutting cycle is HOW MUCH will the Fed cut? The chart below shows the Fed Funds rate and then the 2 year interest rate which is functionally pricing HOW MANY cuts will take place over the next 2 years. Should the Fed cut 100bps? 200bps? 500bps?

The way to make money in the short term interest rate market is by identifying WHAT the market is pricing and IF this is likely to take place. Interest rates are always in a constant state of repricing the future path and speed of cuts/hikes by the Fed. See the interest rate primer on this if you need:

Right now, the forward curve is pricing 59bps of cuts by the end of this year and a total of 125bps of cuts by the end of 2026. If the Fed does not cut by this amount, interest rates HAVE to move up. The Fed Fund Futures are the derivatives that are used to price the path of the Fed’s actions and settle at whatever the ultimate action is.

So the main idea for point #1 is that are we in a situation where the market is asking HOW MUCH will the Fed cut and pricing the uncertainty around this question.

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Point #2:

The Fed is holding short term rates ABOVE short-term inflation expectations. The chart below shows 1 year nominal rates (white) and 1 year inflation swaps (orange). You will notice that over the last year inflation expectations have risen marginally as nominal rates remain flat. The Fed will hold rates HIGHER above inflation if it wants to be overly restrictive in its actions.

All of this brings us to the Fed’s current stance and how its directly linked with HOW the macro cycle is likely to progress.

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The Fed Is Setting The Stage For Macro Volatility: