Tim Duy believes that the Fed will cut interest rates fast enough and far enough to avoid a recession, and that that—rather than a recession—is the scenario driving the current inversion of the yield curve. After the recent declines in interest rates, I would give that only a 50-50 chance of being true. Equilibria are fragile, and multiple. At an equity P/E of 20, a 100 basis-point fall in the very long bond rate should carry with it a 20% increase in equity value, holding risk adjusted expected future cash flows constant. Yet the S&P composite has not moved since late October. That is a hell of a large fall in risk adjusted expected future cash flows:
Tim Duy: On Rising Recession Probabilities: "My interpretation is that market participants have correctly anticipated the Fed’s reaction function with the expectation of substantial easing in the months ahead hence creating the inversion on the short end. This easing will be sufficient to derail impending recessionary threats. If the Fed’s easing was expected to be insufficient, I would expect that the 10s2s spread would be inverted. Consequently, at this point I still do not expect a recession in the near year. Under my baseline scenario, the Fed’s upcoming rates cuts will slightly steepen yield curve and the picture will look like 1995...
...Bottom Line: I agree with the assessment that risks to the economy have grown in the past 6 months. Boiled down to the essentials, the economy is slowing to trend and the multiplying downside risks leave it vulnerable to slowing below trend. The yield curve is telling me that these shocks will not overwhelm the Fed. Powell & Co. can still sustain the expansion and are expected to do so. “Expected” is key of course; the slower the Fed moves, the more likely they are to miss the opportunity to avoid recession. A policy error is a very real potential outcome here. To enhance the odds of avoiding recession, I would advise the Fed to get a 50bp cut done at the next meeting. While I fully expect the Fed to ease at the September meeting, at the moment the Fed seems likely to stick with the less aggressive 25bp cut.
#noted
