The Federal Reserve set off fireworks with its interest rate cut last week.
Reuters polled 101 economists heading into the rate announcement. And 92 of them expected the Fed to cut rates by 0.25%.
But the Fed surprised investors with a 0.5% cut.
The last time the Fed cut by that much, the economy was in freefall during the pandemic.
After the meeting, Fed Chair Jerome Powell made it clear that the focus is shifting away from inflation – as implied by the big rate cut.
But turning away from inflation could impact other areas of the bond market.
Today, let’s look at why outsized rate cuts could spook a $27 trillion market… and deliver trading opportunities along the way…
Will Inflation Rear Its Ugly Head Again?
Congress tasks the Fed with keeping inflation and employment in balance.
Adjusting interest rates is the Fed’s primary lever for fighting inflation or boosting the labor market.
High interest rates slow the economy and labor market to bring inflation down. Lower rates have the opposite effect.
And with last week’s rate cut, the Fed is declaring victory on inflation and switching its focus to employment.
Yet have we truly defeated inflation?
Yes, it has moderated significantly since peaking in mid-2022.
That’s when the Consumer Price Index (CPI) peaked at 9.0%. It was the highest level in 40 years.
Since then, inflation has fallen to 2.5%, just above the Fed’s 2% target.
But core inflation isn’t trending in the right direction. (Core inflation strips out food and energy prices, which are susceptible to wild swings.)
Core CPI has stayed stubbornly high at 3.2% for the past couple of months. The monthly pace of core inflation has even accelerated in the past two months.
And the Fed’s sudden pivot to large rate cuts could stoke inflation once again.
That could weigh on bond prices… and hand us trading opportunities.
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Inflation vs. Bonds
Back when inflation started accelerating in 2021, longer-term bond yields soared.
You see, bonds pay a fixed coupon payment. When inflation picks up, that erodes the purchasing power of income collected from bonds.
So bond yields tend to move higher when inflation is rising.
Let me show you an example in the chart below:
From the start of 2021 to the end of 2022, CPI inflation rose from 1.4% to 6.5%.
In response, the yield on the 30-year Treasury jumped from 1.65% to 3.97% over the same time (the shaded area on the chart).
But bond prices move inversely to yields, which means prices tumbled.
The iShares 20+ Year Treasury Bond ETF (TLT) tracks longer-term bond prices. It lost 34% of its value during the highlighted period.
More recently, as inflation has come in, yields have fallen. But that trend could start reversing.
In fact, longer-term bond yields moved higher immediately after the Fed rate cut.
This could be a sign that inflation won’t stay in its grave.
If the Fed cuts too much too soon, its “soft landing” could get bumpy.
Yet as traders, that’s a sign to look for opportunities amid the transition.
Rising yields just allowed my subscribers in The Opportunistic Trader to grab a 35.5% gain in just two days on TLT put options.
And all else being equal, put options on TLT should continue to gain in value when bond prices are falling. (Similarly, we could use call options if bond prices turn around and start to rise.)
So with the Fed bringing uncertainty back into the economy, I expect plenty more trading opportunities in the bond market ahead.
Regards,
Larry Benedict
Editor, Trading With Larry Benedict
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