A One-Eighty

Neel Kashkari is opposed to rate hikes “at least” through 2023, headlines read late Friday.

By that time, though, it was too late. Kashkari’s “good” cop wasn’t enough to offset Jim Bullard’s “bad” cop act, which set the tone for an abysmal session on Wall Street.

The long-end rallied again, while yields were cheaper at the front-end, flattening the curve further on the heels of Thursday’s dramatics. The 5s30s narrowed to the flattest since September and the 2s10s to the tightest since February (figure below).

Futures volume was elevated. I’m not sure this is what the Fed was aiming at.

“The fact that three-year yields rose… while 30-year rates dropped… speaks to the perception that by bringing forward rate hikes, the Fed is providing a material headwind not only for any inflation that might not prove transitory but also growth as well,” BMO’s Ian Lyngen and Ben Jeffery said. “Needless to say, such a hawkish pivot is likely to remain topical for weeks to come – we’re content to go with the flattener given the broader implications from the FOMC sea change,” they added.

While the market will want to hear from several more Fed speakers before drawing any definitive conclusions, policymakers are on the brink of unleashing a tightening impulse in financial conditions. Higher reals, a stronger dollar and now lower equities could be a noxious combination.

The long-end rally will help bolster the simplest of balanced portfolios, but there’s never really a “good” time for rising reals, dollar strength and falling stocks. I’m not cheerleading for the Fed’s role as bubble maintenance crew — I’m just stating the obvious.

Distortions and ostensible “disconnects” abound. “We expect both real and nominal yields to rise gradually in H2 as post-pandemic bottlenecks get ironed out and yields start to reflect improving fundamentals,” SocGen’s rates team said, in their second half fixed income outlook.

“Real yields rose sharply during the 2013 taper tantrum and in subsequent years on growth optimism, such as the recent ‘Trumpflation’ trade,” the bank went on to say, suggesting that 10-year reals should “rise gradually toward zero with the rise in nominal yields and longer-term inflation expectations remaining above 2%.”

Reconciling all of this is difficult. Deeply negative reals don’t exactly scream “healthy economy,” but they’ve clearly helped bolster stocks trading at historically stretched multiples. How all of this can be happily squared isn’t an easy question to answer.

Obviously, it was a disastrous week for the Dow. The ~3.5% decline was the worst of 2021 (simple figure, below).

“And with that — SPLAT, duration shorts / bear-steepeners / curve-caps unwound, breakevens compressing violently, commodities blasted and cyclical value tapped,” Nomura’s Charlie McElligott wrote Friday, reminding folks that secular growth historically shows a “strong positive correlation with bull-flattening regimes.”

With that in mind, it’s little wonder big-cap tech outperformed the Dow by the second most this year (figure below).

Of course, tech didn’t escape Friday’s rout. “The reverse rotation is continuing,” one fund manager told Bloomberg. “At a certain point, a hawkish Fed isn’t good for anyone, even technology shares.”

The Bloomberg dollar index rose six days in a row, while commodities ended with a weekly loss exceeding 4% after a half-hearted Friday rebound.

Meanwhile, an infrastructure deal is proving to be just as elusive as feared, with talks proceeding on two tracks. Senate Democrats are seemingly prepared to go it alone on some agenda items if necessary, while a bipartisan group of lawmakers continues to push a counter proposal that significantly narrows the scope of Joe Biden’s original plan.

It feels like we’ve done something of a one-eighty. Although the reflation trade was showing some signs of fatigue prior to the June FOMC, the overarching macro narrative still revolved around “reflation,” “overheats” and an irresponsibly dovish Fed in the face of another big fiscal package out of Washington.

Now, commodities are squarely on the back foot, reflation expressions in equities are underperforming, transformational infrastructure looks like a pipe dream and the curve is muttering something about “growth jitters” thanks in no small part to the Fed’s hawkish turn which, as Jim Bullard noted Friday, is attributable to expectations for hot growth.