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These two lines have just crossed for the first time in three years, and it possibly signals the biggest financial shift we've seen since the pandemic.
Traders signal a potential Fed rate hike, possibly triggering a major economic shift and recession risk by 2027.
Key Takeaways
- Traders’ expectations of Fed rate hikes signal a pivotal economic moment with potential recession risks by 2027.
- Core CPI trends suggest inflation is still under control, reducing immediate concerns of aggressive Fed hikes.
- Economic growth may benefit from recent rate cuts, but a large increase in yields could cause significant downturns.
- Historical patterns show Fed rate hikes often precede recessions, but exceptions exist with market corrections instead.
- Understanding macroeconomic cycles is crucial for investors to navigate market volatility and optimize returns.
Summary
- The Federal Reserve's interest rate and the 2-year Treasury yield have crossed for the first time in three years, signaling possible upcoming rate hikes.
- Traders expect the Fed to raise interest rates for the first time since 2022, which historically precedes recessions.
- Institutional traders use economic data to predict Fed moves, often accurately forecasting rate hikes or cuts.
- Higher interest rates have already caused economic pressures like declining real disposable income and stagnant job growth.
- Inflation trends heavily influence Fed policy; falling inflation usually leads to rate cuts, while rising inflation prompts hikes.
- The Fed’s actions today predict US economic growth about a year and a half ahead, with current data suggesting risks for late 2027.
- Core CPI, a less volatile inflation measure, is currently falling toward the Fed’s 2% target, indicating underlying inflation remains subdued.
- There is still a window where the economy can benefit from recent rate cuts, but a significant rise in yields could threaten growth.
- The current environment resembles the mid to late 1990s when falling core inflation allowed the Fed to hold or cut rates, supporting growth.
- Leveraging macroeconomic insights can help investors prepare for market shifts and manage risks effectively.
Chapters
- 00:00Introduction to Fed interest rate and 2-year Treasury yield crossing
- 00:34Historical accuracy of traders predicting Fed moves
- 01:07Fed rate hikes and their link to recessions
- 01:40Current economic pressures from higher interest rates
- 02:15Inflation’s role in Fed policy decisions
- 02:52Fed’s rate cycle and its impact on economic growth
- 04:03Current bond yield trends and economic outlook
- 04:37Core CPI analysis and inflation outlook
- 05:13Comparisons to 1990s economic environment
- 06:13Leveraging macro insights for investing
Full Transcript — Download SRT & Markdown
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This line is the Federal Reserve's interest rate. It's essentially the cost of money set by the most powerful financial institution in the world. And this line, the 2-year Treasury yield, is what traders expect the Federal Reserve to do over the next 24 months. What it's
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telling us right now is that traders believe the Fed is about to begin raising interest rates for the first time since 2022. And if they're right, it could completely change the current economic landscape. The problem is traders do tend to be right about what
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the Fed will do next. And we can confirm that by zooming out and shifting the 2-year yield by 3 months. In the vast majority of cases, when the 2-year yield rises, the Fed actually ends up following through with rising rates.
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Whereas, when traders are betting that the Fed will lower rates, well, the central bank usually ends up actually cutting rates. Now, the reason this is the case is that institutional traders know exactly what kind of data the Fed
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looks at, and hence can get a good sense for what policy decisions will likely be in the near future. And today, traders are betting that the Fed will raise rates in the next few months, potentially dragging economic growth
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into a recession. Because when you look at the influence of the Federal Reserve on the economy, what you see is that every single recession over the past 70 years has been preceded by the Fed raising interest rates as seen in the
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gray bars. And if we add the S&P 500 to the chart, we can see that the US stock market does not like recessions. Now there are rare moments where the Fed did raise rates but it did not lead to a
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recession like these instances here. Although we should note that the stock market did correct in these periods, but still in the vast majority of cases Fed rate hikes spell trouble for US and global economic growth. In fact, we've
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already seen significant economic pressures as a result of higher interest rates such as real disposable income declining and job growth freezing to a standstill. So if traders are right about the Fed being on the brink of raising rates, it could push the US
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economy over the edge as well as the S&P. So yes, we are absolutely at a pivotal moment for the economy and markets. What the Fed decides to do next will probably determine the coming years of economic growth. And by the
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time that most people realize what's happening, the stock market will have already moved. And this is why we do what we do to help you prepare for these macro shifts. So before you panic, it's absolutely critical to understand how
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this actually plays out from here and what the precise timeline for these events will be. And ultimately, it all boils down to inflation. Whenever inflation in the US is falling, traders tend to price in that the Fed will lower
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rates through decreasing 2-year Treasury yields. This is simply because inflation is a reflection of how hot or cool the economy is. So when it cools down, the central bank usually cuts rates to stimulate borrowing, spending, and ultimately economic growth goes up. And
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when the economy heats up again, the Federal Reserve tends to respond with hiking interest rates in order to cool down borrowing and ultimately the economy. The cycle happens again and again and again. Think of this dynamic like the Fed trying to stabilize
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economic growth while avoiding inflation from getting out of control. And we can see that as inflation has come down more recently, the Fed cut rates multiple times, which in turn led inflation to pick up once again, which is why traders
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are betting that the Fed will start a new hiking cycle with direct implications on the economy. We can actually observe this dynamic at play by overlaying US GDP growth on top of 2-year yields. Whenever the Fed raises rates, it tends to hurt growth in the
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year that follows. And the opposite is also true. When rates come down, it tends to boost growth. We can see this even more clearly by flipping 2-year yields around and shifting them forward by a year and a half. It tells us that
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what the Federal Reserve does right now predicts what US economic growth will look like by the end of 2027. And most academic research supports that it takes around a year and a half for interest rate moves to work their way into the
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economy. The only time this relationship wasn't that strong was in the 2010s when the Fed kept interest rates at record lows to help the economy recover from the Great Financial Crisis. But focusing back on what's happening today, the
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recent behavior of bond yields tells us to be extremely cautious regarding what comes next. But it also gives us two very important takeaways. The first is that we are still in the sweet spot where the economy can benefit from the
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rate cuts that began in late 2024. So this tells us that the threat to US growth is a story for late 2027, not today. The second takeaway is that the most recent move in yields is relatively mild for now. It's not yet forecasting a
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massive shift in monetary policy like we saw in the lead-up to prior recessions. In fact, if yields stop rising here, it could be that the Fed only hikes rates a bit or not at all, which wouldn't necessarily have an impact on economic
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growth in a year and a half from now. So, the only real threat to the economy comes if this small rise in the 2-year yield transforms into a much larger increase shown inverted in the chart.
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That is where 2027 growth could really take a hit. Now, we can actually know how likely this bearish scenario is by looking at an alternative measure on inflation called core CPI. It essentially strips out the more volatile components of inflation like food and
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energy. So it provides a more distilled view of actual growth conditions in the US and we can see a clear difference with the normal headline inflation indicator. The core index is smoother and has been falling steadily toward the
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Fed's 2% inflation target. Not to mention it's recently registered a much smaller print than headline CPI. This is important because it tells us that for now the underlying inflation outlook is still pointing down. And if we zoom out,
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we can see that there are plenty of moments where core inflation was close to the current level and the Federal Reserve did not end up raising rates at all or in some cases even lowered them.
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So yes, the fact that rate hikes are back on the table is probably the most important macro shift happening today.
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And if it gets any worse, it could deal some severe damage to economic growth by the end of next year. But personally, we won't get excessively concerned until core CPI starts picking up in a serious manner or if the Fed starts hiking rates
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aggressively, which would actually cause an economic and financial accident. And as we've been highlighting for the past 3 years now, today's environment is most similar to the mid to late 1990s, where falling core inflation allowed the Fed to stay on hold and even cut rates. This
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in turn supported economic growth and fueled one of the strongest stock market booms in history. So, you would not want to miss out on a repeat of this scenario. But even if the Fed is going in the wrong direction, it may not be
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time to expect a severe economic downturn just yet. And as history shows, even as the central bank starts raising rates, the market could still experience one last melt-up before the party ends.
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Topics:Federal Reserveinterest rates2-year Treasury yieldinflationcore CPIeconomic growthrecession riskstock marketmacroeconomicsinvesting strategy
