Which way are rates headed? That’s the big question. Understanding what is holding rates at these levels with little to no volatility is probably a smarter question. Let’s start with the easier part of the question, the lack of volatility. Lack of volatility means lack of changing opinions, lack of game changing or thought altering headlines, a lack of major position realignments and a lack of intuition. Essentially it means no one knows and nothing has come to the forefront to change anyone’s opinion. It’s the Great Not Knowing.
The 10yr is bouncing between 1.70 and 1.80 with the occasional lift above 1.90 before returning right back to the 1.70-1.80 range. Today it trades at 1.76%. It’s becoming Ground Hog Day again, over and over. The Fed says they plan to raise rates soon, depends upon data, play it by ear, watch inflation, jobs, yada yada and the market doesn’t move. Half the market thinks the day of Fed liftoff is coming soon and the other half of the market thinks it’s not happening in 2016. Half the market thinks rates can’t stay this low and half the market thinks US rates are high relatively speaking to the rest of the world. This dance has been going on for four months and counting (or four years depending upon your viewpoint).
In March there was a 42% chance the Fed was raising the benchmark rate in June, now it stands at 4%. In fact the market only prices in a 48% chance the Fed raises rates this year. Ok I lied when I said half the market believes the Fed wouldn’t raise rates this year; it’s actually 48%.
What about jobs and the unemployment rate? Honestly, the market doesn’t care. The Fed has reached their employment goal and yet rates are actually down, what gives? What have you done for me lately Fed, what about inflation? And there is your answer, maybe not the right answer but certainly the answer the market believes is the answer to the big question. It’s still all about inflation and inflation expectations. Trillions of dollars are traded and bet over something as simple as inflation being either 1% or 2%. At 1%, which is the general concession on inflation today (or at least below 2%) the market stays here and rates remain low. If inflation at any point in time hits 2% and there are no job losses then we should see a Fed raise, actually many. If inflation drops below 1% then we will see rates drop from here. How much rates rise or fall if inflation does rise to 2% or higher or fall below 1% could be enormous. Let me repeat that, it could be enormous. The 10yr could move as high as 3% within 6 months or fall to 1.50%. It’s anyone’s guess how far it moves, it really depends upon the exact data and the collective fear it creates in the market.
The point is that the market is in a transitory period, either towards higher inflation or lower inflation. How long we remain here and what direction we move is anyone’s guess. Personally 60% of me says the market can’t take higher rates given what’s happening in the rest of the world (don’t forget about China’s woes). However 40% of me knows that the Fed is ultimately in power and they can do whatever they please, they don’t need the market’s approval. One quick factoid: the current market implied probability that the Fed lowers rates in 2016 is 0%.
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