Another eyebrow-raising inflation print and associated tumult in rates means traders will spend the new week pondering the prospect of an accelerated Fed taper and the timeline on the first rate hike.
Last week’s drama crescendoed on Wednesday, when the combination of an extremely hot CPI report and the largest 30-year auction tail in a decade whipsawed rates, sowing confusion ahead of a holiday for the bond market.
The liquidity discussion is back en vogue and it’ll be front and center this week thanks to an interagency conference on Treasury market functioning. The annual symposium dates to 2015, the year after October 2014’s infamous “flash rally,” during which the 10-year traded in a ~40bps range and dropped 16bps in the space of a dozen minutes before rebounding, all for no obvious reason. The seventh annual conference (on Wednesday) will focus on “recent developments including proposals to improve overall market functioning and resilience.”
A Bloomberg gauge of deviations from fair value suggests liquidity conditions are the most challenging since the chaotic days of March 2020 (figure above).
In many ways, the last several weeks demonstrated how difficult it is for central banks to confront the addiction liability they’ve fostered over a dozen years.
October saw traders price in preemptive rate hikes in the face of surging inflation across developed economies with what looked like policymakers’ blessing. Then, during the first week of November, the powers that be apparently thought better of it. Whatever’s left of the fabled bond “vigilantes” may have scored a small victory by compelling the RBA to abandon yield-curve control in Australia, but Philip Lowe pushed back against expectations for rate hikes in 2022. Over the next several days, Christine Lagarde, Jerome Powell and the BoE all served notice that betting on aggressive, preemptive hikes for risk management purposes is a risky endeavor despite inflation overshoots which ostensibly suggest central banks should be raising rates.
Read more: Spoiled And Spurned
Last week made an already convoluted situation still more ambiguous. Or, as Jerome Schneider, head of short-term portfolio management at PIMCO, put it, “we’re in a transitional period now.”
“In the week ahead, the biggest debate will remain the extent to which the stronger-than-expected CPI report will impact the Fed’s tightening timeline,” BMO’s Ian Lyngen and Ben Jeffery said. “Implicitly, this also brings into question the pace of tapering during the second half of January.”
The marquee data point in the US this week is retail sales, on Tuesday. Also on the docket: The Empire and Philly Fed surveys, a hodgepodge of housing data and a bevy of Fed speakers. Wednesday’s 20-year sale will be watched closely following the long-bond debacle. The MOVE is near the highest since April of 2020 (figure below).
“While the Fed continues to advocate ‘patience,’ the bond markets are growing increasingly impatient,” SocGen’s Subadra Rajappa said. “A faster taper and mid-year rate hike are a possibility,” she added.
For Rajappa, the curve will stay “relatively flat” despite “strong data, improving fundamentals and a return to normal,” all factors that “argue for higher yields.” That speaks to the debate outlined in “Not Everyone Was Gentle: Market Reacts To US Inflation Surge.” The consensus narrative for the nominal curve is that hot data likely gets you a bear flattener, weaker macro a bull steepener. A vicious bear steepener would be reserved for a nightmare scenario where the market gets the idea the Fed has lost control of expectations, a wage-price spiral sets in and/or supply chain bottlenecks don’t abate and inflation broadens out with no evidence to suggest rate hikes can help given the supply-side nature of the issues.
“The 5s30s has been flattening with a momentum consistent with a durable repricing as opposed to simply challenging the recent flats,” BMO’s Lyngen and Jeffery remarked. “This dynamic is in line with the overarching monetary policy implications from a Fed now incrementally more likely to accelerate policy rate normalization.”
For their part, Morgan Stanley is sticking with their call for the Fed to wait until 2023 to hike rates. Late last month, Goldman brought forward their liftoff call to July of 2022.
It’s worth noting (again) that inflation is broadening out. The figure (below) shows the updated Cleveland Fed trimmed mean gauge.
The gap with reported core inflation is now the smallest since CPI took off earlier this year.
If the “transitory” narrative is becoming more difficult to plausibly assert, so too is the notion that inflation is “contained.”
“Overheating and sustained inflation are much bigger risks for the US than for most other developed market economies,” BofA’s Ethan Harris said late last week. “Initially the rise in inflation was limited to a few sectors, pushing up both headline inflation and the traditional core measure [but] over time the price pressures are becoming more broad-based.”
