On Sunday, using an analysis by Deutsche Bank’s Dominic Konstam, we showed why the Fed by miscalculating the equilibrium real rate (which in reality is negative due to the massive debt overhang and the declining nominal growth rate, as well as record deflation exported by every other developed nation and now, China) is about to unleash a major policy error by hiking rates in 3 weeks – a process which will promptly result in a recession and ultimately force the Fed to both cut rates to zero or negative, and proceed with even more QE.

Here is Konstam’s conclusion:

This is the important policy error scenario because even a very shallow path of rate hikes might drive the real Funds rate well above the short-term equilibrium real rate, further depressing demand. It is then plausible that the economy would be driven into recession, and the Fed would quickly be forced to abort the hiking cycle. As an aside, such a policy error could reinforce itself by causing structural damage that puts additional downward pressure on the equilibrium real rate. In this case the yield curve would flatten meaningfully, at least until the Fed actually reversed course by cutting rates.

This scenario is also bullish for rates because the Fed would, at the very least, stop rolling down its SOMA portfolio. More likely it would restart asset purchases in an attempt to stimulate the economy once more, pushing yields further down. We have argued in the past that unconventional forms of monetary accommodation are here to stay. The minutes of the October meeting confirm this view, noting that some policymakers felt it would be “prudent to have additional policy tools” because a lower long-run equilibrium real rate makes it more likely that reductions in the Funds rate alone would not be sufficient to stimulate the economy in the event of a downturn in the future.

Whether or not Konstam is right that the Fed is about to make what will prove to be a credibility-crushing mistake, remains to be seen. However, for those who, like us, believe that anything the Fed does is one mistake after another and thus a December rate hike will merely be the latest one in a long series of policy errors, the question is: how should one trade ahead of this error.

The answer comes from another research analyst at Deutsche Bank, Aleksandar Kocic. Here is his complete trade cocktail in three parts for the next 12-18 months that will encapsulate the distinct phases of the upcoming market tailpsin: the bear flattening of the curve, the bear steepening, one which may see the 10Y trade at or below the 2Y, in the process flattening the curve and perhaps even leading to the dreaded inversion.