Hey There Income Hunter,
Loyal Power Income readers know the value of paying close attention to bonds because they are a predictor of future economic activity.
Like pro bond traders, many of you watch the Fed closely … and it doesn’t take too long to figure how inept our central bank really is.
The key to profits, however, is knowing how to take advantage of the Fed’s incompetence.
Here’s how …
Play the Rates
Profit from the Fed by playing for a shift in rates between the short-term and long-term maturities.
In the US Treasury market, the preferred paired trade is long/short 2-year notes and short/long 10-year notes.
And even if you do not trade this way, the “yield curve” following this spread can be hugely helpful in predicting the Fed’s moves (i.e., what it will do as opposed to what its leaders are saying).
The slope of the yield curve between 2-years and 10-years is a major signpost for where the yield curve predicts the economy is going.
The graph below illustrates the 2-year/10-year curve spread, which is the interest rate on the 10-year minus the interest rate on the 2-year.
Let’s unpack this …
I went back to 2017-2021 to show a complete cycle of spread narrowing until inversion.
In this case, the famous Powell 180 pivot occured … because the Fed always breaks something in the financial system that forces them to go back to what they do best – PRINT MONEY.
You see, the way it’s supposed to work is that, when the economy is weak, the Fed lowers short rates, which widens the 2-year/10-year spread. This stimulates borrowing.
When the economy is strong, the Fed raises short rates, which narrows the 2-year/10-year spread, to depress borrowing, reduce demand for goods and avoid a spike in inflation.
The problem, as I’ve often noted, is the accumulation of debt over the past 40 years that has suffocated economic growth and created a zombie economy similar to Japan.
Over the past four decades, the government and the Fed has always been looking to print money to elevate stock and bond prices. They were just kicking the can down the road for the next president to deal with an out of control debt burden.
The market is finally waking up to this. The graph above shows how quickly investors started taking bets on the spread widening out, knowing the Fed cannot raise rates far and they will have to revert back to money printing to try and continue kicking the can down the road.
Notice how when the Fed was tightening in 2018 by raising rates and draining cash from the market through quantitative tightening (QT) …
The 2-year/10-year curve spread narrowed toward zero until the tightening crashed stocks and forced Powell to promise he would stop tightening.
Every cycle follows a similar pattern:
- The Fed hints at tightening to prepare the market. The market immediately prices in rate hikes via selling short rates and buying long rates. This causes a massive narrowing of the 2-year/10-year spread until it reaches the zero boundary.
- The Fed is always reactionary, so it continues to tighten until something breaks in the system, including debt defaults, a freezing of the funding markets or asset bubble bursts like the 2008 mortgage crisis.
- The Fed quickly shifts back to money printing to prop up the markets … But each time the peak in rates is lower than the previous cycle and the same thing will happen in the months ahead.
Bring It Home
The 2-year/10-year spread went to zero early in 2022 as the investors and traders believed the Fed could stop inflation. Since then, the data has proven that tighter financial conditions are crushing the economy …
This is causing real money to flow back into the shorter maturities because experience tells Fed watchers that the central bank is about to break the system once again, so traders are front-running the Fed.
Yesterday’s S&P 500 close below 4,000 may be the beginning of a crash lower. I think the level that will force the Powell Pivot back to money printing this time will be SPX 3600 – or even a bit higher.
Stay tuned, keep selling the rips and as always …
Live and Trade With Passion My Friend,
Griff