The Fed’s new dance partner

BY TYLER DURDEN

Authored by Michael Lebowitz via RealInvestmentAdvice.com,

The Federal Reserve, bond markets, and economic cycles have been dancing in a well-choreographed fashion for the last 30 years.

This age-old dancing trio, the Fed, yield curve, and economy have a new dance partner. After patiently watching from the sidelines, inflation is flashing her moves. The once predictable partners are falling out of rhythm. 

With inflation running at four times the Fed’s 2% objective, the Fed is anxious to reign it in. However, the bond market and economy warn the Fed to be careful. Will inflation lure the Fed to ignore the economy and markets in its quest to tame inflation?  

In this piece, we explore the dance trio and inflation. The goal is to appreciate better how the Fed may conduct monetary policy in the months ahead. Will they aggressively hike interest rates while the yield curve flashes recession warnings? How will inflation and the economy react if they do raise rates? Lastly, what should we expect from stocks if the Fed opts to fight inflation instead of protecting the market?

Traditional cycles

Since at least 1990, the economy, Fed, and yield curve have repeatedly followed the same predictable cycle. As economic activity heats up following a recession, the Fed slowly raises rates. The yield curve flattens as economic growth wanes. The flattening yield curve ultimately inverts, and the Fed stops raising rates in a year or two. A recession hits, the Fed lowers rates, the yield curve steepens, and the cycle starts anew.

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