There may be alpha in interest rates

There may be alpha in interest rates and this is surprising.

Memo to: Vega Capital clients
From: Scott Shuttleworth


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US interest rates have been a huge topic in the media over the past few months – indeed it’s something that Vega’s algorithm keeps a close eye on.

I’ve noticed a few interesting trends which I think constitute a rare and significant amount of variant perception over these past few months.

Let’s start by considering Vega’s macroeconomic algorithm. Before a recession we would expect to see:

  1. A contraction in the money supply (reducing liquidity in the financial system).
  2. Debt serviceability stress (caused by The Fed raising interest rates too high).
  3. Employment market impact.

Which as a combination, put downward pressure on consumption and thus production. If the contraction in production is significant enough, a recession will be the result (by definition).

As I’ve discussed recently, Vega’s algorithm noted a contraction in the money supply in 2018 and impacts to the jobs market in early 2019. What it’s not seeing yet is sufficient debt serviceability stress so as to trigger a recession but this is changing as rates rise.

And with another 1 or 2 more rate rises, I think that’ll be enough to do it.

So what’s the view on the rates front? Well according to the Fed’s dot plot released after December’s FOMC, we’ve got 2 rate rises coming in 2019…which is why I’m monitoring the data closely.

The market however, seems to think that rates won’t be moving up. In fact, market participants are betting that the chance of an increase is only 5%!

This is quite interesting because it shows that whilst the majority of Fed Board members are biased towards hiking rates by another 50 bp over the coming years the market doesn’t believe them. Indeed, the market believes that the probability of cuts is circa 3 times higher than that of rises.

So why does the market think this?

As far as I’m aware, only one Fed board member has come out publically in favour of lower rates. All others are supportive of either higher rates or at least no hikes until supportive data has come out.

Market participants have also taken comfort from Jerome’s Powell’s use of the word ‘patient’ in his recent speeches. In the minutes of the FOMC released this week, it appears that this term was only used so as to give the Fed time to assess the impact of events such as the US government shutdown, trade tariffs and other issues. It doesn’t appear that this was meant to be a medium-term policy stance which is what the market is now implying.

In the minutes of the FOMC released last week, Fed members were actually divided as to whether rates should be raised if merely economic targets were met or if inflation were exceeding set targets. This is a much more hawkish attitude than contemplating cuts!

In my view, there’s a much higher chance than 5% that the Fed will be hiking in 2019…in fact, I think the probability is well north of 50%....but this doesn’t appear to have been priced into market expectations.

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