where–I think–we are now

The economic part, as least as regards the US, is pretty clear.

The Fed is in the process of raising domestic interest rates to the point where holders of fixed income instruments will be receiving protection from inflation plus a real yield. If we assume the targeted level of “acceptable” annual price rises (i.e., inflation) is 3%, then the ultimate target for Fed Funds is something just north of that, and for the 10-year, a tad above 4%.

The current Fed Funds rate is 2.25% – 2.50%, with one-month T-bills going for 2.57%. Next week, the Fed is likely to raise Fed Funds by 0.75%, meaning the FF rate will be at 3.00% – 3.25%, with one month bills at 3.30% or so. This will presumably put the 10-year at around the 4% mark, or pretty close to the ultimate finish line.

The comparable figures on the first trading day of January were: one-month money at 0.05% and the 10-year at 1.63%. Ytd (including next week), then, we’re up by over 300 bp on the short end and 250bp on the long side.

But there’s still a ways to go. The big economic question is how far.

Let’s also make up some economic numbers for next year. Let’s say current inflation in the US is 8%–and that this breaks out into 4% from energy/food shock caused by one-time, external factors like the invasion of Ukraine and lockdowns in China, and 4% from garden-variety domestic wage-related factors. Let’s also say that external shocks are a net neutral next year. (I have no idea what the actual figures are. My experience is that precision counts for much less than you’d think.) This doesn’t assume anything will get any better, only that things won’t get worse. If so, the “real” inflation the Fed is trying to combat is much less than the headline numbers.

The remaining task, then, is to get 4% inflation to recede to 3%. Btw, Paul Krugman (I’ve recently become a big fan) argues that in the 1990s, non-accelerating 4% inflation was regarded as fine. In any event, I think there’s a convincing case to be made that engineering a return to 2% inflation is not on the Fed’s agenda.

The conventional wisdom seems to be that what’s needed, or at least what will happen is another 75bp higher on the short end, with relatively small upward movement on the long.

As to discounting, i.e., what’s already factored into today’s prices: when market sentiment is bullish, current prices tend to factor in profit possibilities that are one or two, or sometimes even three (this is at the absolute, speculative top) years in advance. When sentiment is bearish, as it is now, the market is stuck in the past, chewing over, again and again, yesterday’s news. That is to say, the market will react to any news (but especially bad news) as it actually happens–no matter how clearly and completely it has been signaled in advance.

There’s a plus to this last, though. If a well-telegraphed Fed move is actually announced and the market doesn’t go down on the announcement, this is evidence that we’re well past peak bearishness, and on the road to the repair of investor willingness to take risk.

more tomorrow

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