Reading Between Interest Rate Expectations

Recently I read an interesting article by Alfonso Peccatiello titled “The Maradona Theory of Interest Rates”:

https://themacrocompass.substack.com/p/the-maradona-theory-of-interest-rates

The idea: the Federal Reserve could play “Maradona ball” with rates - sound hawkish at times, dovish at others, and in the end barely move at all. Since markets were braced for movement, the act of maintaining rates becomes more impactful.

(The name comes from Maradona’s second goal against England in 1986: defenders expected him to pivot left or right, so he ran in a straight line through them. The theory was coined by Mervyn King - who, notably, is now co-leading the Fed’s new communications task force under Chairman Warsh. Alfonso suggests this makes Maradona ball a live possibility.)

What the market is actually pricing

Markets don’t price a single rate path - they price a probability distribution across many possible paths. Futures only give you the probability-weighted average, and an average hides the shape: “one hike priced in” could mean everyone is certain of exactly one hike, or a 50/50 split between none and two. Options on rate futures reveal the full distribution - which is how Alfonso can isolate the tails. Right now the median expectation is 2-3 hikes over the next 12 months, but the option-implied distribution also assigns roughly a 35% probability to four or more hikes. Alfonso’s argument is that this hawkish tail is the mispricing: his models show trend growth, a cool labour market and no inflation pressure in the pipeline - nothing that justifies a one-in-three chance of an aggressive hiking cycle.

Some hawkishness is easy to explain - and a sharp comment under Alfonso’s piece, from Jacob Atticus Kilby, captures why. If nominal growth is running at 5%+ while real growth sits near 2%, the gap between the two is inflation - implying it is closer to 3-4% rather than the Fed’s 2% goal. The actual prints agree: June Consumer Price Index (CPI) came in at 3.5% year-on-year and Core Personal Consumption Expenditures (PCE - the Fed’s preferred measure) at 3.3%. And at the July meeting, three Federal Open Market Committee (FOMC) members formally dissented in favour of a hike. That matters because futures are priced off the expected behaviour of a twelve-person committee. A dissent is a public vote, far stronger information than a speech, and three votes to hike tells you the committee’s centre of gravity is only a couple of hot data prints away from a majority. With Warsh deliberately cutting back forward guidance, votes now carry even more signal than words.

But above-target inflation and a few dissents justify the median (a hike or two) - not necessarily a fat 4+ tail. So what else could be hiding in that tail? I wanted to test a theory of my own - and to show why I’ve ended up abandoning it, because where it fails turns out to be quite interesting.

My theory (and why I’ve abandoned it)

Watching the yen slide towards ¥163 per dollar - its weakest since 1986 -  and ¥183 per euro, my thought was… if the Bank of Japan is forced into hikes, could the Fed hike too - defensively -  to keep Treasuries attractive and stop Japan’s huge holder base (over $1.1tn) from selling in search of better yields at home? A low-probability scenario like that is exactly the kind of thing that could live in a fat hawkish tail.

The problem is that the mechanics run the wrong way, for both types of Japanese investor.

For hedged holders - much of Japan’s institutional money - the cost of hedging dollar exposure is roughly the gap between US and Japanese short-term rates:

•      If the BOJ hikes, that gap narrows, hedging gets cheaper, and hedged Treasuries become MORE attractive to Japanese investors - not less.

•      If the Fed then hiked “in response,” it would re-widen the gap and undo exactly the thing it was trying to protect.

For unhedged holders, a Fed hike only helps if it makes the dollar stronger against the yen. But if the Fed merely matches a BOJ hike - the minor, defensive move in my theory - the rate gap between the two countries is unchanged, so there’s no extra dollar support. What the holder does get is a fall in the price of the bonds they already own. Capital losses with no FX offset. The dollar-strength benefit only appears if the Fed out-hikes the BOJ - a far bigger move than a “defensive” hike implies. And on current domestic data (see Alfonso's charts), tightening on that scale would be unnecessary - which is exactly what would make it dangerous. A hike the economy doesn't need raises debt-servicing costs across heavily leveraged corporate and government balance sheets, and markets would read an unforced move as either a policy mistake or a sign the Fed knows something they don't. Either reading hurts growth and investor sentiment. In other words, the 'defensive' hike only works at a size that makes it self-defeating.

History points the other way too, through the carry trade. For years, borrowing yen was nearly free, so investors worldwide borrowed yen, swapped it into dollars and bought higher-yielding assets (e.g. US equities). A BOJ hike squeezes that trade from both ends at once: the yen loan gets more expensive to service, and a strengthening yen makes the debt worth more relative to the assets bought with it. Leveraged players are forced to sell assets to repay yen loans, dragging global markets down together - and when markets fall hard, traders expect the Fed to cut to steady things. That’s exactly what happened in August 2024… a surprise BOJ hike triggered a violent unwind, the Nikkei had its worst day since 1987, US equities sold off, and markets briefly priced emergency Fed cuts. So the observed pattern is BOJ hikes pushing Fed pricing towards cuts - the opposite of my theory.

What the FX interventions actually told us

The recent yen intervention/s are still worth studying because of how they were carried out and how markets reacted. Over 31 July/1 August - and earlier in the year by Japan independently - the US joined Japan in the first coordinated yen intervention in over a decade, using two unusual tools:

•      The New York Fed sold euro reserves to buy yen, rather than dollars - supporting the yen without weakening the dollar or retreating from the strong-dollar policy.

•      The Fed’s Foreign and International Monetary Authorities (FIMA) repo facility let Japan borrow dollars against its Treasury holdings, rather than selling them.

The second one needs unpacking. When Japan intervenes to buy yen, it needs dollars to sell - and its reserves aren’t sitting in cash, they’re mostly in Treasuries. Normally, raising dollars means selling Treasuries - and that is the fire-sale everyone fears. A bond’s coupon is fixed, so when a huge holder dumps bonds, prices fall and yields rise across the market. That raises the interest the US government must offer on the trillions it borrows every year, and since everything from mortgages to corporate debt is priced off Treasuries – it raises borrowing costs across the whole economy. Done fast, the selling can turn disorderly… other holders sell ahead of it, liquidity thins, and the sight of America’s biggest foreign creditor heading for the exit makes every investor demand extra compensation to hold US debt. FIMA works like a pawn shop. Japan hands Treasuries to the Fed as collateral, borrows dollars against them, and buys them back later. The single most likely trigger for large-scale Japanese Treasury selling was always “Japan needs dollars to defend the yen.” FIMA removes that trigger entirely - and signals the Fed will lend before it lets a forced sale destabilise the bond market.

Read together: Washington would rather sell its euros and lend against Treasuries than let Japan dump them. The “Japan sells Treasuries” scenario is being managed through plumbing, not rate policy - which is exactly why I don’t think it belongs in Fed funds pricing (i.e. whatever is creating that hawkish tail in the options distribution probaby isn't fear of Japanese holders selling lots of Treasuries) .

So my question for the audience: how far does that plumbing stretch? Looking at the EUR/JPY chart recently - and by extension USD/JPY - I’ve noticed moments of abnormally large selling volume (sell euros, buy yen - the visible footprint of government intervention). But it isn’t producing any true reversal in the trend - the yen has already given back roughly half of the intervention rally. The macroeconomic tailwinds that weakened it in the first place - loose and large government borrowing, sluggish growth - haven’t magically disappeared. Personally, I’d say that the more times the US props up the yen without lasting impact, the more desperate these actions will look to the market - and that perceived desperation will only diminish the interventions’ effectiveness further. If the plumbing runs out, what’s the next line of defence?

Verdict

Near-term Fed policy stays dominated by domestic inflation. One or two hikes look plausible; a Japan-driven hike doesn’t - and on the specific question of the 4+ hikes tail, I end up agreeing with Alfonso that it looks too fat.

That doesn’t mean the Yen situation is irrelevant. The fed funds rate is an overnight rate set by committee vote, driven by US inflation and jobs. Long-term Treasury yields are set by global buyers and sellers. Japan’s influence runs through that second category:

•      Long-end yields: if JGB yields rise, Japanese investors need higher Treasury yields to bother holding them over home bonds — pushing 10- and 30-year yields up regardless of what the Fed does.

•      Hedging flows: shifts in hedging costs change whether Japanese institutions are buyers or sellers of dollar bonds — large flows, again mostly at the long end.

•      Risk sentiment: a carry-trade unwind hits equities and risk assets globally, as in August 2024.

In short, watch the yen situation to understand long-term Treasury yields and risk assets. If anything, the only way I can see the yen situation forcing the Fed's hand is in the other direction - a carry-trade unwind or a Treasury sell-off getting messy enough that the Fed has to cut to steady markets. The exact opposite of the defensive hike my theory started with.

Bonus verdict

I also agree with Alfonso that precious metals are still a strong investment considering that interest rates will probably not change too much in the near term.

I started rebuying into gold at around the $4,100 mark, mainly because the slide was showing resistance whilst all of the same macro factors for its growth to $5,000 - in my opinion - remained.

Factors include but not limited to:

Gold has decoupled from any real "fundamental value" a long time ago. It now trades as a vessel for economic concern, amplified by dollar scrutiny and stretched equity markets. It’s arguably and historically the asset closest to the raw concept of "asset" itself - appealing wherever capital concentrates among fewer holders, debt sustainability and inflation fears persist, and real wages fall behind.

Perhaps there is an element of a large enough decline and the psychological floor of $4,000 dollars to reintroduce buying from a lot of portfolios + short positions exiting.

Gold is back up to $4,300+, and I don’t see major reasons right now as to why it shouldn’t continue back towards $5,000.

Thank you for reading. Any questions or responses please comment below or DM me on Linkedin.