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LivestreamMenuThe stock market has been in a tight indecisive range since mid-May caused by a variety of concerns: geopolitical tensions, lingering inflationary pressures, the AI capex spending concerns, the great software meltdown, I could go on. The specific concern we’re going to focus on today is the threat of an increase in the Federal Funds rate as a result of stubborn inflationary pressures from not only the energy prices, but also other areas of the economy. In fact, when I started preparing to write this article Monday, Fed funds futures were pricing in a 95% chance of a hike at the Oct 28 meeting. Just one day later, that chance is down to 83.5%. However, persistent inflation, a resilient labor market and Fed Chairman Warsh’s hawkish tone still remain as market overhangs, with better than 50% odds of higher rates by year-end. Today I’m going to present the case that I don’t think rates are going higher, and this stock market breakout in the summer-range is not an August head fake and likely to continue higher. We’re going to drill down into a key driver of the Fed policy rate to justify my doubt of higher rates, which should open the door for continued gains in equities. Many investors misconstrue the often cited phrase “the Fed controls the short-end of the curve.” As the following charts will show, a more accurate way to describe it is that the short-end of the Treasury curve heavily influences the Fed funds rate. The chart below shows an overlay of the Fed funds policy rate in orange overlaid with the short duration 2 year Treasury yield in blue. Notice how the 2 year yield moves quicker and tends to lead the slower-moving Fed funds in orange. The U.S. 2 year Treasury market is a liquid, actively trading bond market that interprets the economic health of the U.S. economy, and thus the direction of interest rates. The lower panel shows the spread between the two, currently trading 0.47, or 47 basis points. Is that a wide spread? Is the 2 year yield far enough away from Fed funds rate that Fed’s hand will be forced to raise rates? Zooming out 4 decades, we can see the relationship between the Fed funds rate and the 2 Year treasury yield. Looking at this long history and the spread between the two markets makes the question we’re posing all the more interesting. Back to our current-day example, yes, the 2 year yield is rising, but is it sufficiently wide enough to force the Fed’s hand and slow down the economy (and stock market)? Diving deeper into this chart, since 1994, there have been 6 occurrences of the Fed moving the policy rate higher after a prolonged period of declining or flat rates. All 6 examples are labeled with the spread between the higher 2 year Treasury yield and often lagging Fed funds futures. The red rectangles on the top panels highlight the first move higher in the Fed funds rate starting with 1994, followed by 1997. Attached to those red rectangles in the white bubble is the spread between the 2 year and Fed funds. 1994 -120 bps 1997 – 92 bps 1999 – 79 bps 2004 – 160 bps 2015 – 69 bps 2022 – 119 bps Where do we stand today, with a possible 7th rate increase in the next 2 FOMC meetings? Just 47 basis points — almost 50% less than the narrowest spread that triggered a Fed lift off in 2015 (69 pbs). The 2-year Treasury still has quite a ways to rally before the spread is strongly suggesting the Fed needs to move higher. Want a quick way to track that Treasury price? Bookmark CNBC’s bond page and track the 2 year Treasury yield https://www.cnbc.com/markets/bonds/ . Until then, we’ll monitor the chatter of imminent higher rates and take it with a grain of salt while the spread remains below our 70 bps threshold. — Todd Gordon, Founder of Inside Edge Capital, LLC We offer active portfolio management and financial planning for retail investors, as well as regular market updates like the idea presented above. Visit us at https://www.insideedgecapital.com/cnbc DISCLOSURES: None All opinions expressed by the CNBC Pro contributors are solely their opinions and do not reflect the opinions of CNBC, or its parent company or affiliates, and may have been previously disseminated by them on television, radio, internet or another medium. THIS CONTENT IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSTITUTE FINANCIAL, INVESTMENT, TAX OR LEGAL ADVICE OR A RECOMMENDATION TO BUY ANY SECURITY OR OTHER FINANCIAL ASSET. THE CONTENT IS GENERAL IN NATURE AND DOES NOT REFLECT ANY INDIVIDUAL’S UNIQUE PERSONAL CIRCUMSTANCES. THE ABOVE CONTENT MIGHT NOT BE SUITABLE FOR YOUR PARTICULAR CIRCUMSTANCES. BEFORE MAKING ANY FINANCIAL DECISIONS, YOU SHOULD STRONGLY CONSIDER SEEKING ADVICE FROM YOUR OWN FINANCIAL OR INVESTMENT ADVISOR. Click here for the full disclaimer.Read More
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