MBS Day Ahead: Pondering Paradoxical Effects as Markets Circle Wagons For Fed Week

Everyone knows the Fed is considering hiking its target rate for the first time in 9 years, bringing it up from all-time lows for the first time in 6 years, and that it could happen some time soon.  But no one can really know what that will ultimately mean for markets--especially the markets they're most interested in (which, if you're reading this, probably at least includes mortgages and/or longer term interest rates). 

The anxiety-inducing news is that markets have definitely begun circling the proverbial wagons for next week's potential Fed hike.  Even before China's currency drama sent shockwaves through markets 2 weeks ago, Treasuries were already trading in the fateful "expanding cone of volatility" pattern.  But since then, both stocks and bonds have clearly been consolidating.  This is classic "triangle" behavior, and we're meant to think that it sets the stage for a bigger break higher or lower.

Of course it's totally reasonable that we'll see a big move higher or lower next week.  Yes, I said "OR LOWER."  See, there's this conventional wisdom--an accepted ideology, if you will--that a Fed rate hike connotes higher rates in general.  That's definitely been true many times in the past, and it could indeed be true this time as well.  But it's ever-so-important not to assume that it will be.  There are no sure things when it comes to the future of interest rates, and I'd argue that for every correct guess about what rates will be doing in a day/week/month/year, there are many more incorrect guesses.

Bottom line, we have recent historical evidence of the paradox playing out before our very eyes.  Most of us aren't too young to remember 2004.  By June of that year, the Fed Funds rate had been pegged at its lowest levels for the longest time that any of us had seen (You'd have to be really old to have remembered lower rates, and even then, they weren't nearly as prolonged). 

At the same time, 10yr yields were spiking violently after a 3 year rally of a lifetime (6.8% to 3.2% from 2000 to mid 2003).  By the time the Fed hiked in June 2004, 10yr yields were up to 4.86%,  But that's as high as they'd go for almost the entire cycle of Fed tightening.  In a few short months, they'd rallied nearly 100bps.

Moral of the story: it doesn't always happen like everyone thinks/says.  Oftentimes, Treasury/MBS markets have done a great job of pricing in the Fed's future rate path, and by the time the hike/cut finally happens, rates markets are already moving on to the next act.