“Very unusual-looking.”
That’s how one rates strategist described the trajectory of the implied path for policy rates at a time when inflation is running rampant in the world’s largest economy, and the Fed’s belated efforts to tamp it down are seen as increasingly likely to push the US into recession.
At the front-end, it’s been an exceptionally wild ride over the past several months. The updated figure (below) is simple. It’s also poignant.
“The two-year rate has traded in an exceptionally wide range, provoked by a drastic reshaping of the expected fed funds path over the next 24 months,” Deutsche Bank’s Steven Zeng remarked.
He was referring specifically to the past six or so weeks, but the fireworks started months ago. The tumult crescendoed during the week of the Fed’s June meeting, when it was left to the Wall Street’s Journal‘s Nick Timiraos to telegraph the Committee’s intention to up the ante following two disconcerting data points which hit during the pre-meeting quiet period.
The figure (above), overlays the two-day net change in two-year yields. The Friday-Monday jump that encompassed May CPI, the preliminary read on University of Michigan inflation expectations for June and the Timiraos article was towering.
Fast forward a month and another hot CPI report briefly prompted traders to price a coin flip’s chance of a full-point hike from the Fed at this month’s meeting. A cooler-than-anticipated read on the preliminary vintage of Michigan inflation expectations prevented déjà vu all over again.
Expectations for aggressive front-loading and a concurrent deceleration in economic activity have created a tug of war of sorts. Two-year yields are both juiced by rate hike expectations and capped by them, a scenario exemplified by a good tactical two-year short call from TD’s Priya Misra late last month. She put the trade on when a string of poor data fanned recession fears and took profits following last week’s inflation data. “Market pricing of the terminal rate rose from 3.25% when we put the trade on to 3.6% [and] while rates can sell off further, high volatility and ongoing worries about recession should prevent a move higher in front-end rates,” Misra said.
Deutsche Bank’s Zeng described the ebb and flow. “For the two-year sector and rates more broadly, pricing of higher terminal rates is bearish, but the effect is ultimately neutralized and even trounced by rate cut expectations, particularly if the expected timing of cuts keeps creeping closer,” he wrote.
The figure (below) shows how the timing of the first rate cut has been pulled forward by a full year since the onset of Fed hikes (light blue line).
Markets now expect the Fed to reach the terminal rate (pricing for which has increased substantially this year in line with scorching inflation and the Fed’s mark-to-market SEP exercises) at the December meeting.
“The market is now anticipating the first 25bps rate reduction in early June 2023, compared to late July just last week,” Zeng went on to say, noting that “this probably prevented the two-year rate from jumping even higher after the red-hot inflation report.”
This raises the question I explored at some length in “Game Over.” Namely: Where do central banks go if markets (and the economy) simply refuse to countenance the amount of policy tightening necessary to rein in inflation?
What happens if off-the-cuff Jamie Dimon is right (or at least more right) than on-the-call Jamie Dimon? What happens if “that hurricane” is, in fact, “right out there, down the road, coming our way,” and it gets here before the September FOMC meeting?
