Kolanovic Says Fed Rate Hike Pricing Now ‘Too Much’

Some of the acute imbalances that drove inflation in developed economies to generational highs may be on the verge of working themselves out, even as the conflict in Ukraine could prolong the commodities rally.

That’s the message from JPMorgan’s Marko Kolanovic who, earlier this week, suggested a unique confluence of circumstances makes it possible for investors to construct a kind of dream barbell thanks to acute de-rating in previously frothy sectors like tech, biotech and innovation and improving prospects for yesteryear’s value traps, which now look like better fundamental bets thanks to a shifting macro environment.

“Last year, we were among the first to point to significant inflation upside, but now think that some leveling off will happen due to the transitory nature of the COVID impact, underappreciated YoY base effects and softening demand as growth slows down,” Marko said.

There is a benign version of demand destruction. We typically only talk about the extremes because, let’s face it, that’s what makes “news.” But, as Kolanovic suggested, demand can slow both as a function of naturally decelerating growth and gradual policy tightening. Cooler demand could help offset lingering strains on the supply side, exacerbated recently by lockdowns in China and, of course, the war.

If some of the imbalances contributing to inflation do work themselves out, Marko said “we could see some hikes getting priced out of the curve, especially as we get closer to midterm elections.” He even floated the idea of the Fed “stopping later in the summer.”

As a reminder, market pricing suggests this will be the briskest hiking cycle many market participants have ever witnessed. As the figure (below) shows, we’re talking very rapid. The x-axis is the number of days from the first hike, and the red line is market pricing for the current cycle.

You’d be forgiven for questioning the Fed’s resolve. Jim Bullard’s Volcker impression notwithstanding, there are legitimate questions about the viability of a plan to go from zero to 300bps in 12 months (or less) while aggressively running down the balance sheet, all into the teeth of a decelerating economy and ahead of midterm elections that were already going to be a challenge for the President’s party.

On Wednesday, BofA said that on some metrics, “inflation concern has reached manic levels” in the US. The bank cited Google searches for inflation in the course of suggesting (see the chart header, below) that Americans are simply not accustomed to rising prices and are thus becoming obsessed.

“Another piece of evidence for the almost-manic focus on inflation is the extent of mutual fund inflows into inflation-protected Treasury funds since 2019,” the bank’s Ralph Axel said, noting that BofA’s “forecasts point to inflation peaking this quarter and falling steadily into 2023,” which he said should “reduce the panic level around inflation and allow rates to decline.”

For his part, Kolanovic wrote that “when it comes to rate hikes, we think that too much is now priced in and interest rates may level off from here.”

Some of the move, he said, “was due to a large shift in systematic strategies such as CTAs,” whose bond beta fell by ~0.9 this year on JPMorgan’s models, which to Marko “suggests they may have sold ~$300 billion of 10-year equivalents in global bonds.