Buy Bonds Now?
Today is all about getting the Paper Alfa house ready for Christmas. And there is tons to do; it’s a drill which I thoroughly enjoy doing every year. However, before the tree gets erected, I just wanted to send a quick update following yesterday’s FOMC meeting. I was wrong. Jay did not come out in a silver or blue tie; instead, he chose purple. I shall update the records accordingly. He is clearly more fashionable than I thought.
The good news is that the models worked like a dream in the run-up to the meeting (full update as usual tomorrow). Even though I thought that he would be leaning against current near-term market pricing, everything the market really cared about was the planting of those ‘24/’25 dots by 50 bps lower compared to their September projections. While Jay didn’t totally take off the probability for further rate hikes, everything the market heard was as loud:
The Fed's overall outlook for the economy and unemployment didn't change meaningfully from the September forecast. A slightly more benign outlook for inflation was the background that led policymakers to pencil in 3 rate cuts for 2024 and 4 in 2025. Markets now discount close to 6 rate cuts next year and another 3 in 2025. That’s more than 200 bps of cuts loaded into the front-end over the next two years. In my piece on Taylor rules and optimal control, I opined that a gradual move of inflation back to 2% would justify a policy rate of 4%, all things being equal. That’s not too far from the Fed’s median 2025 Fed funds projection of 3.6%. The Dec 25 SOFR implies 3.18%, which includes a fair share of a recession premium in addition to the Taylor rule dynamics. As such, would I load up on bonds here? The answer is no. I don’t know why they have chosen the path that has now even put in a small probability of a January cut and cemented the first full rate cut by March 2024. Justifying such pricing by inflation and growth dynamics alone will be hard to accomplish, in my opinion, given that we have even overshot a soft-landing scenario.
Our momentum model has taken us long bonds in early November at around 4.6% in US 10s. It’s nicely in the money, and there is no need to chase it. Yes, we have broken the 200 ema on yesterday’s move, and I’m sure plenty of latecomers will chase this rally further. I will be using further rallies to reduce my long bond short. Risk-reward and my above logic on pricing would dictate such a move.
As usual, I will follow up with the full chart pack in tomorrow’s Friday Paper Charts.
Best of Luck out there!