Recently, we've seen the U.S. dollar strengthening significantly and interest rates rising rapidly. Many are wondering if this is a result of the so-called Trump trade. For instance, the yield on the 10-year U.S. Treasury has risen by more than 10 basis points (bps) compared to earlier this year. If we had projected interest rates at the start of the year, how accurate would those predictions have been? While there's still time left in November and December, it's clear that this year’s interest rate volatility has been more unpredictable than most.
Looking Back: Was This Year Truly Exceptional?
To say this year was unlike any other might be a stretch. Last year, we experienced similar volatility. Let’s rewind to October 2022: back then, U.S. rate hikes, the UK bond crisis, and domestic issues like the Legoland crisis in South Korea all contributed to a rapid increase in interest rates. In August 2022, after the U.S. credit rating downgrade, Treasury yields quickly surged. Following the Silicon Valley Bank (SVB) crisis and resulting concerns about the banking system, the 10-year U.S. Treasury yield dropped to 3.7%, only to later skyrocket to 5.0% by late October.
That’s when the Federal Reserve and the U.S. Treasury began working together. The Treasury reduced its issuance of long-term bonds and shifted toward shorter-term bonds. Meanwhile, Federal Reserve Chair Jerome Powell did an about-face, signaling potential rate cuts. This led to a sharp drop in Treasury yields, with the 10-year yield falling below 4.0% by the end of the year.
The Start of 2024: Expectations vs Reality
With expectations for rate cuts running high, January 2024 kicked off with the market pricing in seven rate cuts from the Federal Reserve by the end of the year. Similarly, the Bank of Korea was expected to reduce its rates by around three times, starting after the general elections. The twists and turns of this year are likely fresh in your memory.
Interest rate movements have been influenced by clear but opposing factors. When these factors arrive simultaneously, they tend to limit upward or downward movement in rates. However, when they emerge in sequence, they create significant volatility. This trend is expected to continue next year, as we’ve seen over the past three years where the fourth quarter often brings sharp rate increases followed by sharp declines.
Narratives vs Fundamentals: What Really Drives Markets?
The biggest reason behind the dramatic movements in interest rates and exchange rates is that markets are driven more by narratives than fundamentals. And when we do look at fundamentals, it seems that the underlying structure of the economy may have shifted.
Since 2022, I've often quoted Michael Hartnett of Bank of America, who identified three major shocks: the inflation shock, the interest rate shock, and the recession shock.
The Inflation Shock
When inflation surges, central banks respond by raising rates quickly. But as rates rise and inflation persists, fears of a recession grow stronger. Markets know all too well how cautious the Federal Reserve is. When recession fears take hold, the Fed typically preemptively cuts rates.
The Interest Rate Shock
Before the Fed officially cuts rates, markets often act in anticipation, driving market rates down sharply. What results is a cycle where rates spike, fall rapidly due to recession fears, and then bounce back again as inflation picks up once more.
The Recession Shock
This cycle is also accompanied by U.S. exceptionalism, where U.S. assets and consumption patterns drive the economy. This exceptionalism, seen in everything from the stock market to consumer spending, often fuels economic recovery. However, the stronger the U.S. recovery, the more likely inflation is to reemerge. As inflation rises, the argument for rate hikes becomes stronger, reversing expectations of rate cuts and leading to a sharp rise in market rates.
A Cycle of Learning: Faster and More Intense
Over the past two years, this cycle of inflation, rate hikes, and recessions has repeated itself. The question now is whether we will see this cycle repeat again. The difference this time around is that the market has learned from past cycles. The result? The pace of the cycle seems to have accelerated.
Earlier this year, we saw inflation unexpectedly rise, erasing any pivot expectations that had been building. This inflation shock caused a sharp increase in rates, with the 10-year Treasury yield rising to 4.7%. Then, by the summer of 2024, fears of a prolonged high-interest rate environment caused recession concerns to grow. These recession fears fueled pivot expectations, which were further supported by an actual rate cut in September.
U.S. Exceptionalism and Sticky Inflation
Let’s take a closer look at U.S. exceptionalism. This concept suggests that the U.S. economy and asset markets are distinct from those of other countries, primarily because of their strength and resilience. The stronger the U.S. economy, the more likely it is to sustain robust consumer spending and asset market growth.
But there's a downside to this strength. The more resilient the economy, the stickier inflation tends to become. Higher growth and stronger consumer demand could mean that inflation rebounds faster, making it harder for the Fed to keep prices stable. Combine this with Trump trade policies, which are fueling inflationary expectations, and we may find ourselves in a scenario where inflation remains stubbornly high.
The Dollar Loop and Inflation Persistence
In 2015–2016, we dealt with what was known as the "dollar loop," where the world struggled to escape a deflationary spiral. Today, however, the situation is reversed. Inflation has proven to be much more persistent than anticipated, and we’re now dealing with the repercussions of three significant shocks—inflation, interest rates, and recession. Escaping this cycle will be a challenge, but it’s essential if global markets hope to stabilize.
In conclusion, the financial markets are navigating unpredictable cycles driven by inflationary pressures, rate hikes, and recession fears. As these cycles repeat and intensify, the market is learning and adapting, speeding up the response to changes. Whether the current cycle will repeat or finally stabilize remains to be seen, but one thing is certain: navigating these waters requires a clear understanding of both narratives and fundamentals.
By keeping a close eye on inflation, interest rates, and U.S. exceptionalism, we can better anticipate the twists and turns ahead.