With the various flavors of the Taylor Rule (see last week’s posts for more on the Taylor Rule) now declining due to moderating inflation and a rising unemployment rate, the Fed has some room to eventually give back a few of its rate hikes. The forward curve expects a 4% funds rate over the next few years, which seems appropriate if inflation levels off at 3% and the neutral real rate is 1%. But perhaps rate cuts are a story for 2025.
Either way, after mounting concerns that the Fed might have to hike again, the latest data give it some space to stay on the dovish side of the pivot spectrum.
Does that mean we can stop worrying about rate tantrums via the Fed model? Not quite. While the Fed model (which tracks the difference between the equity P/E and bond P/E) is miles away from the infamous 1987 extreme (when rising bond yields caused a crash in stocks), it has moved quite a ways since 2020. Bonds went from being 89% too expensive to being 5% cheap. The historical average is around -25% (which accounts for the equity risk premium).
All in all, It appears that bonds have declared a truce for now, with the 10-year yield declining to around 4.5% last week. But bonds are now positively correlated to equities, which means that we need to keep looking over our shoulder for rate tantrums, and keep our portfolios diversified in other ways.