A Preliminary Pontification on Papa Powell's Potentially Pivotal Pivot

As a great poet (probably) once said, “To pivot, or not to pivot? That is the question…”

So, Drake, the question remains: To pivot or not to pivot?

For starters, even the most sophisticated investors have changed their minds more than your girlfriend changes her mind when you ask her where she wants to eat for dinner. For reference, see the chart below (data collected from Fed Futures prices per the CME).

Before we begin, let me say that it is a pointless endeavor for any normal investor to try to answer this question, as the outcome is highly dependent on understanding a sickening amount of the interworkings between economic principles, psychology, and financial markets, as I will soon describe. Luckily for you all, I happen to put the hot in psychotic, so I naturally am going to have to figure this out for my own personal satisfaction.

Now that we got that out of the way, let’s get into it.

To start, we need to understand how the Fed determines its monetary policy; for this post, it'll be exclusively focused on the Federal Funds Rate. It has three primary mandates, which include:

1) Promoting full employment and stable prices

2) Maintaining Stability in the banking system

3) Ensuring safety and efficiency in their payment systems (the Fed is doing a bit better than FTX on this, so I won’t discuss it much, as there are minimal risks outside of the Digital Dollar)

Price Stability has been the talk of the town. Inflation has been almost as crazy as your psycho ex-girlfriend when she found out you started dating someone else; NOT good. Your ex-girlfriend may have been a 2.00%, but now you’re with a 7.75%. While bigger is often better, that 7.75% has caused things to overheat a bit. Yes, I am referring to inflation and the economy, not your new sidepiece.

In fact, the most recent CPI reading was so encouraging that a Fed pivot seemed like an impending reality, evidenced by the sharp decline in forecasted Fed Funds rates and long-term Treasuries. This occurred despite changes in CPI measurement that could have understated inflation.

Bringing inflation down has been the #1 goal of the Fed as of late and they’ve reiterated that they are “strongly committed to bringing inflation back down to (their) 2 percent goal”. We all (don’t) remember the 70's and 80’s and how bad inflation was back then; while I love a good sequel, that’s one I’d like to kindly pass on. No thx.

Full Employment is the maximum level of employment that the economy can sustain without generating unwelcome inflation.

The unemployment rate is 3.7%, which is historically low and is likely causing wage-push inflation because, as I’m sure you know, there’s been a labor shortage for the last few months. Jerome Powell has also explicitly stated that the unemployment rate will increase due to the monetary policy induced economic slowdown.

“The broader picture is of an overheated labor market where demand substantially exceeds supply. Job creation still exceeds… the level that would hold the market where it is. We want wages to go up… at a level that’s sustainable and consistent with 2 percent inflation (ideally through) job openings declining.” – Jerome Powell, 11/2/2022 FOMC meeting speech.

Employment levels appear to be a bit overheated, though there is some noise due to price inflation and wage inflation being a circular reference (wage push inflation).

Banking System Stability is based on valuation pressures, excessive borrowing by businesses and households, excessive leverage within the financial sector, and funding risks that could lead to bank runs. I have many thoughts on this, but would encourage you to read the first few pages of the Fed’s report detailing this further. This is extremely important, though often undiscussed, as systematic risk and stability have been largely unimpacted because defaults, delinquencies, and doubts in the lending system have remained low.

Ok, GREAT. We know what the Fed bases their policy on. How can policy change?

Oh… I am so glad you asked.

Thingys that investors should consider:

1) Velocity (speed) of rate hikes (How fast the Fed raises rates)

2) Maximum rate (The maximum rate the Fed targets)

3) Terminal rate (The longer-term interest rate the Fed targets)

4) Lag in market impact (How long it takes for the market to realize the impacts of interest rate increases)

The Velocity and Maximum Rate appear to be stable over the last month. I believe that it’s reasonable for the Fed to continue hiking rates into the beginning of 2023 and hitting a peak of 5% in the middle of 2023. Though there is debate regarding the Fed reducing interest rate hikes from 75bps to 50bps in the upcoming FOMC meeting, the velocity and maximum rate have not changed significantly. Not to discount these factors too much (pun intended), but the terminal rate and lag in market impact will have a larger impact on the market and economy and should be the focus of the investor’s attention.

The Terminal Rate, or the rate the Fed will seek to maintain over the long-term, is critically important. We can use the 2YR and 10YR Treasuries as a proxy for understanding what the Terminal Rate could be.

Short term interest rates on debt (the 2YR in this example) are calculated based on a blended series of discount rates; those discount rates represent the term structure of interest rates. In fact, long-term interest rates are based on the same premise, though they also include a term premium because of their longer-tenure (you get paid more because your money is invested for longer).

If, for example, 1-year interest rates are expected to be 5% this year and 4% next year, you’d calculate the price of a bond as seen below:

That results in a bond price of 91.575 and a YTM of 4.498%. Huh, guess it’s just a coincidence that this is the same YTM that 2YR treasuries are traded at…

Because 10YR Treasury YTMs are a similar combination of short-term rates, the lower YTM on 10YR Treasuries suggests that the Terminal Rate will be somewhere below 3.7% (accounting for a term premium, it’d probably be 2.5%-3.0%). The higher the expected Terminal Rate, the higher the 10YR goes, meaning more contractionary monetary policy, meaning less economic growth and (hopefully) less inflation. This is one of the many reasons why the 10YR treasury is so important.

The Lag in Market Impact is one of the great mysteries of this whole dilemma. The (very) general consensus is that there is a 12–24-month lag before the full impact of monetary policy impacts the economy (plz note I did not stay the stonk market). Even if a 9-month lag was reasonable (which is unlikely), the full effect of monetary policy still hasn’t impacted the economy, as the first rate hike occurred in March of 2022 (you know what else happened during the month of March? If you guessed COVID, you get 1,000 points!). What has impacted the market thus far is some monetary policy (haven’t heard of anyone able to quantify this), rising inflation, and Hysteresis.

“Hysteresis, Drake? Now you’re making up words to prove your point? This has gone too far!”

I wish I had made it up. Hysteresis suggests that negative shocks to the monetary supply permanently reduce total factor productivity (growth through technological advancement). In normal people terms, if people think the economy’s going to take a dump, that probably means demand will fall, reducing company’s incentives to invest in growth projects. The chart below shows how Hysteresis can impact an economy (as it did in ’08).

The best way to combat a permanent reduction in output is “if the central bank strictly targets inflation and the nominal interest rate is away from the zero lower bound (which results in) no output hysteresis.” – Boston Federal Reserve. Huh, sounds like that’s exactly what the Fed’s been doing. So, the question we should be asking is what is the long-term interest rate that will help the Fed meet their target inflation.

Okay, here’s a recap of where we’re at:

- Out of control inflation is the most important issue because it’s bad for the economy.

- Raising rates will help slow inflation, but it could lead to permanently lower output (Output Hysteresis).

- The terminal Fed Funds rate is one of the most important considerations and is what most people mean when they refer to the “Fed pivot” (though the Fed has never explicitly stated what their long-term target Fed Funds rate is).

- In determining future Fed policy rates, investors not only need to gauge current market conditions, they also need to forecast future market conditions and make estimations as to how a group of economists will digest that information with or without the perceived influence of public opinion. That, my friend, is impossible (for most).

So, what long-term Federal Funds rate will help the Federal Reserve meet their target inflation rate of 2%?

Um, ya, idk… in fact, I don’t think anyone really knows (hence all the volatility).

“DRAKE, after all that, you’re going to do us dirty like that?”

Um, ya?

“But how am I gonna make some (capital) gains this Holiday season?”

As we discussed, the velocity of rate hikes and the maximum rate are important, but they are not the critical factors; the lag time of rate hikes and the terminal rate are the most important numbers, as they will impact the economy more.

To make our analysis actionable, you need to make an assumption regarding whether you think the market is correct or incorrect regarding the long-term path of interest rates, specifically if the long-term Fed Funds Rate will be above or below 3.7%-3.9% (based on 10YR treasury YTM and Fed Futures rate for 2026, respectively). If the long-term rate is above that estimate, go short. If below, go long. This, of course, is looking at interest rates in isolation of all the other factors.

Though we haven’t experienced most of the effects of monetary policy (which is reasonable based on a significant amount of scholarly research), cutting rates early could lead to many unintended consequences, such as giving high inflation a second life. I’d be surprised if the Fed lowers the terminal rate below our 3.7%-3.9% band over the next year or two, as cutting too quickly could lead to inflation remaining high for years to come. An additional point to consider, however, is that companies still haven’t experienced the full impact of rate hikes yet, indicating that even if the Fed cuts interest rates sooner than expected, companies' financials and the U.S. economy as a whole may still be negatively impacted by the delayed impacts of high interest rates.

My parents told me not to make my posts too long, so this is where I am going to conclude this article. If you want me to rant about a specific topic in the future, let me know!

Also, this is where I turn into a content creator and ask for your thoughts, feedback, insight, questions, concerns, and hypotheses.