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Powell May have Reversed Four Decades of Market Dynamics

Jeffrey Gundlach is the revered fixed income (read: "bonds") investment manager who founded DoubleLine Capital. I only identify him because he made some public statements about the upcoming path of interest rates in early January that are relevant to what's going on now.

Bloomberg quotes him in a webcast as having said: "My 40 plus years in finance strongly recommends that investors look at what the market says over what the Fed says".

Context: by "market", he means the bond market. Through its summary of economic projections, we know that the Fed's rate setting committee is projecting the Fed Funds rate to surpass and stay above 5 percent in 2023. Because there are no walls between interest rate markets, the rate on two year treasury bonds is known to have a built in expectation of what markets "think" the Fed will do with the Fed Funds rate over the next two years. In early January, Fed Funds was 4.3 percent, the Fed was projecting a rate above 5, while the two year bond rate was less than 4.5. In other words, the Fed was telling us that the rates would surpass 5 percent, while the bond market was telling us that they would not. When the two entities disagree, Gundlach says, "Listen to bonds".

That has historically been solid advice. A little less than 40 years ago (1987), Alan Greenspan took over chairmanship of the Federal Reserve. The Greenspan Fed never held Fed Funds higher than the two year rate, and his successor, Ben Bernanke, followed the same program. Chairman Powell also heeded the 2 year rate when the committee stopped hiking rates in 2019.

Blue - Fed Funds

Green - US 2 Year Bond Rate

A recent jump in US dollar interest rates across the board suggests those days may be over. Over the four trading days since the Fed's last meeting, the two year bond rate jumped about 35 basis points, and the rates on Fed Funds Futures Contracts followed the same path.

Dark Blue - Fed Funds contract for Dec '23

Light Blue - Fed Funds Contract for Jun '24

Yellow - Fed Funds Contract for Jun '25

While I dislike the tendency of observers to talk about markets as one contiguous entity, sometimes it cannot be avoided, so here it is: Historically, the bond and rate markets seem to have been the ones to put a "lid" on how high the Fed takes its policy rate. What has followed some months later is the tendency of the Fed to be forced by circumstances (recession, market crash or crisis) to cut rates again, for which the 2 year treasury rate was used as a guide. Gundlach's rule of thumb, "listen to the bond market", arose from this pattern.

This pattern may have been broken in February 2023, as bond and rate markets have reversed three months of downward expectations and priced in an additional rate hike. This leaves me asking, is the Fed in the driver's seat this time? At this juncture, it does seem that Chairman Powell can "talk" markets into pricing more hikes if he so chooses.

But the important question is, how should this affect investment decisions? Investors should focus less on front running the Fed and more on what bonds, money market funds, and Certificates of Deposit can get them, relative to other assets.

A money market fund will currently pay you 4.55 percent to take your money and lend it to the Fed (yes, that Fed) on an overnight basis, and you can pull your cash out at any time. Your investment advisor should be taking this opportunity on your behalf. The only question should be percentage allocation, and they should have a well-thought-out explanation as to how they determine that your allocation.

If they still have you allocated to 60+ percent stocks and the remainder to bonds in 2023, fire them.


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