Chart of The Week: Rate Rotation

We have 3 Macro Themes that we work with quarterly. From an investment process perspective, these investment themes are generally born out of one another (for example, in Q1 we had Breaking The Buck and come Q3 that morphed into Burning the Buck).


Our views of the deflation/inflation cycle have been expressed via our Q3 Theme of Reflation’s Rotation (reflating prices from their lows of y/y deflation) and now what we are calling for in Q4, a Rate Rotation (born out of accelerating y/y growth and price data).


Politicization of the US Federal Reserve aside (which you shouldn’t set aside), the two things that the Fed should care about in setting rate policy are:

  1. Growth
  2. Inflation

On the Growth front, at this point a monkey can tell you that Q4 GDP will be positive. On the Inflation front, the monkeys still need to be fed more data.


Altogether, GDP and CPI are lagging indicators, so we need to have a proactive forecast that bats at a higher average than the dismal forecasting one held by Bernanke’s stint  at the helm of the US Federal Reserve.


In terms of reported y/y deflation, the July 2009 CPI report of -2.1% is going to be the low for this part of the cycle. The October and November CPI reports are going to continue to be less deflationary, sequentially, and the bond market is already figuring this out.


Recently, TIPs and Gold have already traded at their YTD highs, discounting that reported deflation is a rear-view concern. As a result, now we see interest rates starting to discount the Fed hike that we have been calling for. Yesterday, the Fed futures had an 86% probability baked into the cake for a hike to 0.50% by the April 2010 meeting.


Only a month ago, probabilities weren’t betting on a hike until Q3 of 2010. Goldman still has NO hike for 2010 as their call. We’re on the other side them.


The question now is how right are the moves in both the 2-year and 10-year yields that Andrew Barber and I have outlined in the chart below? The two lines that matter most in our Macro model on this front are the TAIL lines. The TAIL, in our language, is the longest term duration that we use to manage risk (3 years or less).


The TAIL breakout line for the long end of the curve has held up since the US stock market started reminding the Depressionistas that this isn’t a Great Depression in April/May. On the short end (2-year yield) is where you see fits and starts of breakdowns and breakouts –this is called the politicization of the short end of US policy making.


When Bernanke finally signals that ZERO isn’t a perpetual policy, expect 2-year yields to blast off from this 0.98% level. A Q4 Rate Rotation is finally underway.



Keith R. McCullough
Chief Executive Officer


Chart of The Week: Rate Rotation - a1


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