Gu Chaoming: Soaring interest rates are approaching a critical point.

What's the next move for the Federal Reserve? Nomura warns that interest rates have reached a critical point and the Federal Reserve should "think twice" before taking action. Societe Generale warns that if interest rates continue to rise, a repeat of the 1987 "Black Monday" may occur.

On October 19, 1987, the Dow Jones Industrial Average plummeted by 22.6%, a day later known as "Black Monday." In October of that year, global stock markets lost $1.7 trillion, with 19 out of 23 major markets experiencing declines of over 20%.

Recently, Gu Chaoming pointed out that soaring interest rates are approaching a critical point where risk asset prices will experience significant volatility. The real estate and other interest rate-sensitive industries have already reacted to the rise in interest rates, but the stock market and other risk assets have not fully priced in the aggressive rate hikes by the Federal Reserve. If interest rates reach this critical level, the idea of a soft landing for the US economy will no longer exist, and the market may collapse, potentially leading to another balance sheet recession.

Albert Edwards, a strategist at Societe Generale, known as "The Big Short," pointed out that if the Federal Reserve continues to raise interest rates, the rising US Treasury yields will attract more investors to the bond market, dealing a devastating blow to the stock market. The current resilience of the stock market is reminiscent of the "Black Monday" in 1987.

Gu Chaoming also pointed out that despite the Federal Reserve's previous rate hikes and multiple warnings from Chairman Powell, the yield on the 10-year US Treasury bonds has been fluctuating slightly between 3.5% and 4.5%, without significant increases or decreases.

Gu Chaoming believes that this situation has occurred because the market believes that inflation will be under control in the short term and short-term interest rates will decrease. However, if market participants realize that the actual situation is different, asset prices based on these expectations may suddenly correct.

The September Federal Reserve monetary policy meeting, which ended two weeks ago, kept interest rates unchanged. However, the dot plot released by Fed officials after the meeting signaled a hawkish stance, with over 60% of officials expecting another rate hike this year to respond to the unexpectedly strong US economy.

At the same time, the median projection for interest rates in the next two years was raised by 50 basis points compared to the previous projection. This means that the Fed expects the number of rate cuts next year to potentially be halved to two times.

Gu Chaoming said that although it is difficult to predict where the key point of interest rates is, what is worrying is that since the Federal Reserve hinted that interest rates will have to remain at a higher level than expected for a longer period of time, bonds have been in turmoil, with the 30-year Treasury yield rising to 5.05% at one point and the 10-year Treasury yield surpassing 4.88%, both the highest levels since 2007.

Gu Chaoming believes that when market interest rates do not change in response to the policy rates set by the Federal Reserve, the Fed's monetary policy will no longer be effective. The Fed's decision to stop raising interest rates while U.S. Treasury yields continue to rise may affect Powell's next move:

An important consideration for Powell's decision to pause rate hikes in September and cautiously move forward with the next steps is that he is concerned that rates may be approaching a key point, and gradually approaching a key level may force the Fed to pause rate hikes.

In a report last week, Edwards pointed out that with interest rates rising rapidly, the "uncertainty of the U.S. economy's future" has increased, coupled with the "fiscal malaise" - record budget deficits and debt impasse, pushing the 10-year U.S. bond yield above 4.7%.

Edwards believes that as U.S. Treasury yields rise, the resilience of the stock market reminds him of 1987, when the optimism of stock market investors was ultimately extinguished:

The rising U.S. Treasury yields provide investors with higher safe returns on investment, which may lead to more and more investors withdrawing from the higher-risk stock market. Do you feel like you're sitting in a car, knowing you're about to crash, but powerless to stop?

Just like in 1987, any signs of a recession now are sure to have a devastating impact on the stock market.

The Fed may stop raising interest rates

Gu Chaoming pointed out that in recent years, the impact of monetary policy has weakened, forcing the Federal Reserve to increase its rate control efforts, making the U.S. economy increasingly vulnerable to asset bubbles and balance sheet recession cycles. Concerns about approaching critical points may prompt the Fed to stop raising interest rates:

In the case of the Fed stopping rate hikes, there have been changes in the bond market, which has a positive impact by eliminating the need for Fed action, but I suspect the Fed is also concerned about the risk of losing control. In this sense, I expect the Fed to not only closely monitor inflation trends, but also closely monitor the movement of bond market interest rates.

The Fed certainly does not want market interest rates to change more than policy rates, causing major problems.

Nick Timiraos of "New Fed Communications" recently warned that the surge in long-term bond yields in the United States is destroying hopes of an economic soft landing, and the sharp increase in borrowing costs could significantly slow economic growth and increase the risk of a financial market collapse, which could weaken the rationale for the Fed to raise rates again this year. As for where the critical point is, previously, Nomura Securities analyst Matsuzawa pointed out that the inversion of the 3-month to 10-year US Treasury yield curve could be one of the critical points triggering a technical contraction in the US economy and credit, and he believed that this would force the Federal Reserve to pause its rate hikes. Matsuzawa wrote in the report:

In many cases, the economy and credit will continue to expand as long as the policy rate and market rates have not reached a certain critical point. However, once this critical point is exceeded, even if the policy rate remains unchanged, the economy and credit conditions will enter a technical contraction.

The inversion of the 3-month to 10-year US Treasury yield curve is an important turning point, and another indicator is the real yield of US Treasury based on inflation forecasts.

Last Tuesday, the real yield on the 10-year US Treasury briefly exceeded 1%, which is on par with the level reached during the previous economic cycle when economic activity entered a technical contraction at the end of 2018.

Image source: Nomura Securities

We believe that the US economy and credit environment will continue to deteriorate until November, which will force the Federal Reserve to pause its rate hikes.