A Rate Cut Is Coming - Here's How To Know When

|
Includes: DDM, DIA, DOG, DXD, EEH, EPS, EQL, FEX, FWDD, HUSV, IVV, IWL, IWM, JHML, JKD, OTPIX, PSQ, QID, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWM, RYARX, RYRSX, SCAP, SCHX, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, UWM, VFINX, VOO, VTWO, VV
by: Eric Basmajian
Summary

The bond market has fully priced in multiple rate cuts in the next several months.

The yield curve inversion has spread to bills which means the rate cut is coming in a matter of months.

Which part of the curve will send the signal?

At this point, most market participants and media talking heads are fairly certain the next move from the FOMC is a rate cut rather than a rate hike. Now, that sounds like a silly comment but just a couple of months ago, some pundits were unconvinced a rate cut would be coming in 2019 and even some major banks were predicting 3-4 rate hikes this year.

The bond market has forced market expectations and has brought everyone on to the side of rate cuts, the only question is when.

Earlier in 2019, when most were still calling for potential rate hikes, I was discussing a possible rate cut in June as the front end of the yield curve inverted late in 2018. At the time, that was laughed at by some and while a rate cut in June remains a low probability event, it has become a common discussion.

As of this writing, based on implied probabilities via Fed Funds Futures, there is about a 25% chance of a rate cut in June, more than likely too low for the Fed to act.

By the July FOMC meeting, those market implied odds jump over 80% which means the market is making a bet that the first rate cut will be in July, about six weeks from today.

By December, the market is wrestling with the odds that the Fed will have cut rates two times or if December will be the third 25 basis point rate cut, quite a radical change from one year earlier.

I have spent a significant amount of time discussing 30-year rates and the back half of the curve in many of my previous writings.

Today, as the market pulls forward the idea of an imminent rate cut, it is a good time to discuss the inversion of the yield curve that has emerged in Treasury bills.

Dating back to December of last year, and even as late as January of this year, the spread between Treasury bills was positively and normally sloped. The 1-year rate was higher than the six-month rate which was higher than the 3-month rate and 1-month rate.

Inversion In Bills:

Yield curve inversion

Source: Bloomberg, EPB Macro Research

Late in 2018, the market was still assessing some probability that the Fed would perhaps increase interest rates again and thus, priced in a spread across the bills curve to account for a potential increase in the Fed Funds rate.

Starting in January of 2019, after the stock market meltdown, but more so in March and April, the bills curve started to invert as the market became convinced that the next move was a rate cut and that the rate cut would be coming within the next 12 months.

We can see in the chart of the 1-year Treasury rate below when the market started to price out rate hikes. Late in 2018, the 1-year rate started to tumble from a high yield of 2.74%. The 1-year rate was drifting lower before plunging in May. The plunge in May was the market signal that a rate cut in the next 12 months is a near certainty.

Inversion In Bills:

Source: Bloomberg, EPB Macro Research

Moving over to the six-month rate, we see a similar but less pronounced drift lower from November 2018 through May 2019. In May, a similar plunge took place in six-month rates which, again, signals that the market is convinced a rate cut by year-end is a near certainty.

Inversion In Bills:

Source: Bloomberg, EPB Macro Research

As we move closer to the front-end of the curve, the drift lower did not start until April of 2019. The market will not lower 3-month rates until a rate cut is more imminent. Starting in April, 3-month rates started to drift lower and have now fallen about 25bps.

Inversion In Bills:

Source: Bloomberg, EPB Macro Research

Similarly, the 1-month rate has drifted lower, but only starting mid-way through 2019 as opposed to at the back-end of 2018. 1-month rates have declined roughly 25bps as well but we have not yet seen the plunge as we did with 1-year and six-month rates.

Inversion In Bills:

Source: Bloomberg, EPB Macro Research

For those not watching the short-term rates, it is time to start shifting some focus to Treasury bills for the signal on when the rate cut is coming. If we see the 3-month and 1-month rates start to dive, as we saw with 1-year and six-month rates, the rate cut is likely coming in a matter of weeks.

By studying baskets of leading indicators on growth and inflation, members of EPB Macro Research were able to position across the Treasury curve before this sudden decline in interest rates, beating the crowd to this major inflection point.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.