Author Topic: Is the assumption of falling rates a crowded trade?  (Read 567 times)


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Is the assumption of falling rates a crowded trade?
« on: June 07, 2023, 02:48:56 PM »
It seems most investors* are assuming interest rates will rapidly fall from here. Evidence:

1) The CME's Fedwatch tool uses futures market data to estimate the probabilities of various rate outcomes. The probability spread shows most investment in FFR futures is following a narrative that the Federal Funds Rate will be the same in December as it is today, and that by next June we will have had 75bp of rate cuts.

2) Comments from banking veteran @chasesfish suggest that commercial real estate developers are not refinancing their construction loans from banks into more permanent loans, even though the rates for temporary loans are usually variable and around 8%. I suspect they aren't willing to pay the cost of committing to an interest rate now because they assume rates will be lower in the future. They know that if rates rise instead of fall, they will have even worse options in the future than they have now, but they're making the bold bet anyway (perhaps because their projects can't earn their cost of capital if interest expenses are locked in at today's rates, so they might as well play for time and get the option of having a profitable project in the future).

3) Home prices are still high, despite mortgage rates rising to near 7% and affordability being lower than it was in 2006-2007. The people stretching to buy houses now may be assuming they can refinance in a couple of years at 4-5%, if not lower.

4) The S&P500 is trading at a TTM PE ratio of 24.7 (an earnings yield of 1/24.7=4.05%) and massive forward earnings are expected. Per Yardeni the forward PE is an optimistic 18.5 (an earnings yield of 1/18.5=5.4%). You can beat or match either of these earnings yields with a one year FDIC-insured certificate of deposit right now. The rationale for taking the riskier bet for a lower one-year yield is that rates will fall in the near future and cause expansion of stock PE ratios back to the 30's. According to this view, holders of expiring CDs would be left behind, with only pricey stocks or low interest rates to reinvest in.

5) The US treasury yield curve is very deeply inverted right now, which only makes sense if markets believe dramatic rate cuts are coming. Otherwise it would not make sense to tie up one's money for a longer period of time at a lower interest rate than one could get by tying up one's money for a shorter timeframe.

Everywhere you look, people seem to be placing big bets that the Fed is about to cut rates dramatically, which makes me wonder if this has become a crowded trade. Imagine if a severe recession somehow failed to materialize, and we found ourselves in June 2024 with a 5.25% or higher FFR and a less inverted yield curve than we have today.

That scenario could happen if:

a) We have a mild recession accompanied by inflation that remains stubbornly above 2% and the Fed refuses to cut rates due to the risk of inflation returning like in the 1970's,
b) We have no recession and the Fed pauses rates where they are today, as they did from July 2006 to July 2007 or January 2019 to July 2019.
c) Inflation takes off again as another commodities price boom occurs, unemployment stays low, wage gains start spiraling, and people resume pulling ahead their consumption again, leading the Fed to raise rates.

Any one of these outcomes could be catastrophic for property owners holding short-term, variable-rate CRE loans, because those loans would start expiring right into the face of high interest rates. Additionally real estate values could come down as people lose hope in the possibility of refinancing. Rising or stable rates could also drive stock valuations lower if the 10-year yield starts to exceed 4%.

Recall that the S&P500 hit a recent bottom on 10/12/22, which was also the day the 10-year yield peaked at 4.25%. As the 10-year yield fell over the past 8 months, stock prices rallied. Ten year rates could adjust upward if the FFR was kept high for a long enough time. Exactly this scenario happened between 3/1994 and 11/1994 after a ~300bp series of rate hikes was followed by a 1% increase in 10y yields over the 8 months following the plateau in the FFR.

Anyways, it seems like the market is pricing a nearly zero percent probability of any outcome except a series of rate cuts happening very soon, and that's dangerous. To be fair, I also think rates will be cut soon, but I'm far less certain about that prediction than the market seems to be. I'm also reluctant to crowd into a trade when everybody seems to think the same thing, because that outcome is already priced in and any other outcome will come as a negative shock. What are your thoughts on the actual odds of rate cuts rather than any other outcome?

*the same investors who just last year never thought rates would get this high


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Re: Is the assumption of falling rates a crowded trade?
« Reply #1 on: June 07, 2023, 05:24:51 PM »
I think it depends on your timeframe.   If you are trading options with an expiry in the next 2 months, it is a crowded trade.  The forces that could/would drive rate cuts in the 6 month time frame are pretty powerful.


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Re: Is the assumption of falling rates a crowded trade?
« Reply #2 on: June 07, 2023, 10:38:01 PM »
Canada up another quarter today.

tldr:  <rubs hands in glee at savings account>


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