When Will They Listen?

"They" say you have to constantly post fresh social media content to gain influence.?But what if there's nothing new to say??I'm not doing a good job as an influencer. The macro/rate story is still unfolding about they way I described it nearly a year ago and it is approaching it's ultimate denouement.?Yet again, markets want the Fed to say it's about finished and the Fed refuses to cooperate.?Yet again, the terminal Funds rate target gets ratcheted upward.?Hopes get crushed.?Pundits say the Fed forecasts are fallible - they're right but the direction of the errors is not favorable for the bulls.?Some pundits say maybe the Fed should tolerate higher long-term inflation. That's crazy talk.

So while my forecasts haven't changed let me talk about what the long-term equilibrium interest rate levels might look like if/when the Fed is ultimately successful.?Let's start with what I hope are non-controversial propositions.?1) The Fed thinks 2% is the "right" rate for inflation and long-run inflation expectations. 2) The Fed is determined to reach a condition of positive real rates.?That is, yields some amount above inflation, something we haven't seen in a good many years.?I'll risk a third proposition that (3) we should see a "normal" yield curve, one is one that is moderately upward sloping, reflecting only a risk premium for longer maturities and no discounting of rising short-term rates or inflation in the future.

I am happy to debate any of these propositions but let's assume they're correct.?Reasonable levels for interest rates come pretty simply from them.?This may seem a banal exercise but it is interesting because it frees us of the recent hindsight bias that anchors so many forecasts.?First, a real Funds rate of about 1% leaves us with a nominal Fed Funds rate of 3%, a level which gives the Fed ample flexibility to cut or raise rates as any future credit cycle requires.?A number of academic studies have decomposed the yield curve into the (a) risk and (b) forecasting components and usually arrive a at a risk premium component in the 0.5% to 1% range.?That premium is the compensation investors require for taking on greater price volatility in longer-dated bonds. Given the structural increase in bonds outstanding, rising volatility and reduced liquidity, I will wave my hand and say that 1% is the new normal. That takes us to a 4% long-term bond yield.?Another thing "they" say is a 2% real interest rate is what savers should expect to earn on their money.?Is that the short-term rate??If so, set the rate structure to 4% and 5% for for T-Bills and long bonds, respectively.

What is the path to get to my imagined equilibrium??I'll waffle about this but note that a 3.4% 10-year is?already in accommodative territory... in a two percent inflation world.?Not cheap, especially if inflation is going to remain north of 4% for the next couple of years.?It's tough to ring the "buy" bell for bonds, despite the negative slope of the curve.?As I've mentioned before, the Fed needs to see a "capitulation" in credit markets and it hasn't happened yet.?The path to a 4% bond yield goes through 5%.?There are several signs of a slowdown, to be sure, but markets are discounting a soft landing when there are many sectors of the economy that haven't experienced a contraction yet.?Being a credit guy, I look to corporate bond spreads and, up and down the rating scale, spreads are not pricing in a slowdown, much less any distress.?These are "Goldilocks" spreads.?You might say I should trust the forecasting ability of the market and, depending on my mood, I might agree with you.?Unfortunately, there is no convincing value proposition in the credit markets with spreads at these levels.?

Look again at the chart of high-yield spreads at the top of this post. Bond spreads are mean-reverting and if we get to 7.5% on the series above, I will feel much better owning high-yield credit and bonds in general. 4.4% over Treasuries ain't doing for me.

So, for now, I am still on the sidelines and if we do actually accomplish a soft landing, I'll miss the game entirely.?I suspect there are some fireworks yet to see, though.