US Rates In Search Of Consensus As Fed Leans In

“There’s no consensus on the inflation outlook, or prospect of one in sight,” Bloomberg’s Liz McCormick wrote, over the long holiday weekend in the US.

Previously, that lack of consensus (and the extreme ambiguity that facilitated it) manifested in a near total abandonment of the US long-end as a proxy for longer run macro outcomes. In the face of an impossibly convoluted outlook, markets focused almost exclusively on the front-end, “as short-term monetary policy actions [became] the only factor to which probability could be assigned,” as Deutsche Bank’s Aleksandar Kocic wrote this week, reiterating points from previous notes.

Seen through that lens, April, and particularly last week, are notable. Longer-dated yields led the way higher and then, a slightly cooler-than-expected core CPI print served as a catalyst for a large midweek rally in twos (figure below).

There’s now some speculation that the re-steepening which typically follows inversions on the eve of recessions has been brought forward this cycle, just like everything else. Remember, it’s not the inversions you should fear, but rather the subsequent re-steepening.

To be sure, I haven’t heard anyone suggest this is “the moment,” so to speak. That is, while the move lower in two-year yields (which were more than 30bps off their 2022 highs at one juncture last week) in part reflects a paring of rate hike bets, it’s likely a function of profit-taking too.

John Williams on Thursday underscored high odds for a 50bps move at next month’s FOMC and as Deutsche’s Kocic noted, Fed funds futures are “consistent with inflation vigilantism of the 70s and 80s and in clear discord with this century’s gradualism.” The figure (below) gives you some perspective.

The x-axis is days since liftoff for a given tightening cycle and the red line is just the market-implied policy rate trajectory for the current cycle. As Kocic went on to write, “even the 2004-2006 cycle appears gradual despite aggressive rise of inflation and highly operational transmission mechanisms from liquidity to inflation in the background of lax regulation.”

So, the pivot to easing is hardly imminent. Indeed, the tightening has barely started. But, again, everything has happened at warp speed this cycle. And I can’t help but wonder if Fed officials’ emphasis on how much “tightening” they’ve already effectuated merely by talking about it (and via tapering), reflects a recognition among policymakers that they may not be able to deliver on the dots and/or market pricing.

Either way, there’s certainly an argument to be made that it’s in the price — that even if the Fed does manage to somehow execute the most aggressive tightening cycle in decades just as economic momentum is waning, rates have mostly priced that in, so the next move is to pull forward the inevitable pivot once the economy slows enough to force a rethink.

“The move higher in US rates has been a function of strong economic data and a hawkish Fed committed to price stability [but] we believe the hiking cycle is well priced at this point,” TD’s Priya Misra and Gennadiy Goldberg wrote, recommending a long in three-year Treasurys and adding that they “expect the Fed to become more cautious about hiking beyond neutral as they try to achieve a ‘soft landing.'” It’s also conceivable the Fed will eventually dial back the aggressive rhetoric once inflation starts to decelerate.

This is the reality rates are attempting to cope with and negotiate. The US docket is devoid of top-tier data in the new week, but the market will hear from plenty of Fed speakers, including Bullard, Evans, Daly and, most importantly, Powell, who’s set to speak alongside Christine Lagarde at an IMF event on Thursday.

“In the week ahead, the Treasury market will evaluate the sustainability of not only the latest leg of the selloff in bonds, but also the steepening of the curve that has pulled 2s10s, 5s10s and 5s30s back from inversion,” BMO’s Ian Lyngen and Ben Jeffery wrote. “Fundamentally, there is little on the data calendar that holds the needed macro weight to materially shift the broader outlook and that will leave our focus on the incoming Fedspeak as well as the price action itself heading into the FOMC’s pre-meeting communications moratorium.”

As for the prospect of 10s sustainably breaching the disinflationary downtrend that defined the four-decade bond bull market, it’s worth noting that the composition of rate rise matters. “Long-end rates are ultimately a function of Fed policy expectations over the long run (i.e., the neutral rate) and term premium (i.e., the equilibrium between the supply and demand of duration),” TD’s Misra wrote, in a separate note.

“There’s a feedback loop between long-end real rates, financial conditions and the outlook for the economy,” she added. “The rise in long-end real rates can be self-limiting if real rates tighten financial conditions excessively.”