Bet On The Fed, Not The Macro

“Confusing.”

That’s as good a description as any when it comes to assessing US rates, where the only thing that’s a semblance of clear is the market’s focus on short-term monetary policy as the only reference point where probabilities can be assigned.

Fed speak this week revolved around the notion that the pace of the taper might need to be accelerated commensurate with surging inflation. Efforts on Jerome Powell’s part to de-link the taper timeline from the first rate hike haven’t met with much success.

The biggest mystery is why long rates aren’t higher. One plausible explanation is simply that the longer the Fed stays behind the curve, the more likely it is that rate hikes will be aggressive. All else equal, aggressive rate hikes can throttle growth. And then there’s the prospect of another COVID wave. Austria’s nationwide lockdown and institution of a vaccine mandate were a poignant reminder that the pandemic is very much alive and still capable of leaving scores more dead.

While noting that rates are higher across the board compared to this time last year, BMO’s Ian Lyngen Ben Jeffery wrote that there’s still “much investor consternation regarding the lack of selling pressure in 10s and 30s even as the belly of the curve has adjusted to the forward progress by the Fed.”

Given the return of macro volatility and unprecedented ambiguity around the path of the economy and particularly inflation, market participants simply can’t take a view on the long-end.

Instead, the market is placing bets on how the incoming data will impact policymaker psychology and thereby how inflation prints will manifest in the Fed’s reaction function.

“While the current action revolves around the front-end, with anxieties centered on the Fed reaction function with an outlier spike in the upper-left corner vol, during the taper tantrum, it was the long-tenor vol which outperformed,” Deutsche Bank’s Aleksandar Kocic wrote Friday.

Again, this partly reflects the perception that although some of the ambiguity inherent in the inflation outlook is embedded in the Fed’s reaction function (which is in part a derivative of the macro), it’s easier to assign probabilities to the near-term policy response than it is to the longer-term economic outlook.

Of course, the near-term policy response could itself impact the trajectory of the economy, which makes it even more difficult to take a view on the long-end. As BMO’s Lyngen put it, parsing the nominal curve “is complicated further by a ‘hawkish’ Fed seeking to offset supply constraint-inspired inflation and thereby risking derailing the recovery prematurely.”

Ultimately, Kocic thinks long rates are too low. “Apart from being misaligned with the front-end and not fully reflecting the economic numbers, the announced Fed focus on employment and lower NAIRU are seen as supportive for higher long rates,” he remarked, adding that “exercising ‘patience’ by the Fed implies somewhat longer accommodation in order for the labor market data to improve.”

The Fed has consistently maintained (implicitly and, in some cases, close to explicitly) that some near-term pain on the inflation front is worth it if it ultimately means facilitating a return to full employment.

Preemptive rate hikes for the express purpose of managing inflation risk aren’t consistent with that, especially if the balance of Fed voters believe incrementally higher policy rates are unlikely to make much of a difference given the source of price pressures (concentrated on the supply side).

A patient Fed “should be bearish for rates, especially for the long end,” Kocic went on to write. “Less threat of hikes would allow risk premia to build up beyond the Eurodollar sector.”

How a prospective fifth COVID wave in the US would impact all of this is hard to discern. On one hand, it would bolster the case for Fed patience, thus removing some of the risk associated with policymakers inadvertently tightening the economy into a slowdown, but it would also introduce a macro headwind (as opposed to a policy headwind) to the growth outlook, which would presumably be bullish for long-end yields.

Lyngen captured it well. “Confusing the policy calculus all the more is the potential fallout from a winter wave of COVID cases that threatens to undermine the budding confidence of US consumers attempting to reengage in the in-person economy.”