No Doves Allowed

Weary investors can look forward to a short break from escalatory Fed rhetoric. Officials are in the media blackout ahead of the May policy meeting, at which the Committee is virtually guaranteed to deliver a 50bps rate hike.

The perception of policy panic prompted a flurry of bearish trades across the US rates complex last week, when the combination of Jim Bullard’s 75bps trial balloon, Jerome Powell’s endorsement of front-loaded hikes and remarks from Mary Daly (among others) played absolute havoc. The surge in demand for 75bps hike tail hedges suggests traders aren’t convinced the front-end selloff has run its course, nor are they convinced enough rate hike premium is built in. As mentioned here on several occasions, that can become self-fulfilling. Dealers need to hedge their exposure to those (for now OTM) options structures, and hedging flows could exacerbate any additional downside in STIRS if the market moves to new lows.

Given that, radio silence from the Fed is probably a good thing for now. Officials are countenancing (even encouraging) the market to align itself with an aggressively hawkish policy trajectory. Given inflation realities (and concurrent political considerations ahead of the midterms), a dovish lean seems anathema in the near-term.

That’s consistent with a desire to cap stocks. Equities accounted for the majority of the FCI easing impulse post-pandemic, and the Fed doesn’t want their tightening progress impeded by a run back to records. Goldman estimates financial conditions need to tighten further, and if the lion’s share of that is achieved through the equities channel, it would take the S&P around 15% lower.

“This observation has been the basis for my long-standing view that the Fed is effectively ‘shorting S&P calls,’ particularly as real yields continue to remain too negative and financial conditions too ‘easy’ for their inflation-hawking needs,” Nomura’s Charlie McElligott said, suggesting that, at the least, equities will “remain stuck in a range-trade until we finally begin clearing the actual hikes and QT runoff event and the distribution of outcomes can again narrow, which will eventually bleed rates vol.”

Colloquially speaking, it’s gonna be a while. 10-year real yields have surged, and indeed they moved briefly into positive territory last week, which added to the angst in stocks (see the pink dot in figure on the left below). But note that even after some 140bps of tightening, Goldman’s US financial conditions index still ranks in just the 6th%ile going back more than 30 years.

At the same time, sticky (higher) inflation expectations are problematic on two fronts. First, they indicate that the hawkish banter isn’t resonating. Second, higher breakevens mechanically push real yields lower, perversely easing financial conditions. Note that 10-year breakevens hit a record on Friday (figure on the right, above), while real yields ended the week back in negative territory.

“In the week ahead, the Fed’s pre-meeting communication moratorium will leave Powell’s ’50bps is on the table,’ as the final official guidance ahead of the May 4 rate decision,” BMO’s Ian Lyngen and Ben Jeffery remarked, calling the bearishness in the Treasury market “undoubtedly impressive as yields across the curve converge around 3%.”

Note that the nascent steepening was snuffed out by last week’s front-end fireworks. The 2s10s flattened nearly 30bps from local wides. The figure (below) illustrates the evolution of the dynamic over the past three weeks.

It looked, briefly, like the Fed trade was exhausted, and the bearish impulse had migrated out the curve. Now, there are calls for dip-buying in the supposedly “cheap” long-end against the above-mentioned pushing-of-the-hawkish-envelope in 2s.

That’ll make Tuesday’s two-year sale interesting, and the neutral/terminal rate discussion will also be relevant for Wednesday’s five-year sale. “Coming out of the weekend, we’ll look for the concessionary impulse of front-end supply to add to the move as the ongoing chatter of dip-buying in duration has thus far held 10-year yields below 3%.” BMO’s Lyngen and Jeffery went on to say, in the same note cited above.

“For the time being, 2.977% marks the height of the selloff, and while that does not preclude a move through 3%, we suspect the market is approaching the point at which sidelined investors will begin to take advantage of yields at levels not seen since late 2018,” they said, of 10s.

SocGen, meanwhile, tweaked its US rates forecasts. The bank now sees 10s “overshooting” to 3.25% in Q2 or Q3. Subadra Rajappa cited still accommodative financial conditions, a strong labor market, rising wages and higher savings rates in suggesting that “so far, all signs point to a resilient US economy.” So far.