Friday’s ‘Fed Pivot’ Trade Explained

On Friday morning, in “The ‘Unstable Dynamics’ Behind Treasury ‘Scarefest’,” I wrote that all coverage of US rates in 2022 needs a caveat to account for the fact that virtually everything is stale upon publication.

Rates volatility, I said, is “now such that time-stamping charts is necessary in order to avoid confusion,” because by the time you read a given article or analyst note, markets might’ve moved dramatically.

True to form, US rates were whipsawed Friday by Mary Daly and more so by Wall Street Journal “Fed whisperer” Nick Timiraos, who said, in the drop head of an article published at 8:32 AM ET, “some officials are signaling greater unease with big rate rises to fight inflation.”

Timiraos described the Fed as “barreling toward” another 75bps rate hike next month. That language might’ve been purposeful — meant to underscore the idea that not everyone at the Fed is completely comfortable with the 75bps cadence going forward.

Between Timiraos’s piece and remarks from Daly about an eventual “step down” in the pace of hikes, five-year US yields careened wildly, trading in a 20bps range. The figure (below) shows you the impact of the Journal piece on peak rate pricing.

In my opinion, it’s not optimal for one journalist to exert as much sway over the most important market in the world as Timiraos plainly does over US rates, particularly at a time when Treasurys are increasingly fragile and illiquid.

Although 75bps remains a virtual certainty for the November FOMC meeting, it appeared Friday as though Timiraos and, later, Daly, were attempting to convey the possibility that officials could signal a willingness to opt for a relatively less aggressive 50bps move at the December meeting.

There are two crucial points:

1. The September CPI report was viewed by many market participants as a good argument for what would be a fifth straight three-quarter point move at this year’s final policy gathering. Although the balance of Fed speak over the past two weeks was unapologetically hawkish, the Fed may want to preserve their optionality for December.
2. The SEP from the September meeting tipped 125bps in additional tightening over the last two meetings of 2022. At the time (so, last month) that was seen as a very hawkish dot plot. But, in the press conference, Jerome Powell emphasized that there was still a “fairly large group” at the Fed who saw 100bps over the balance of the year. 75bps at both remaining meetings would therefore be 25bps more aggressive than the already hawkish consensus and 50bps more hawkish than the “fairly large” dovish contingent. It thus wouldn’t be surprising if the Fed is uncomfortable with the prospect of the market prejudging a meeting that’s still almost two months away.

The likes of Jim Bullard have repeatedly suggested the Fed might consider pulling some of 2023’s tightening forward to the December meeting. There’s not a lot of tightening priced or expected for 2023, so that can really only mean 25bps. Patrick Harker was very hawkish on Thursday, calling the Fed’s progress on inflation “frankly disappointing” and suggesting rates would be “well above” 4% by year-end. “Well above” probably means 4.50%.

Given all of that, it’s fair to suggest there’s a possibly contentious, if still generally collegiate, debate going on behind the scenes not around the size of November’s hike, but around the appropriate course of action at the December gathering when markets will be treated to a dot plot refresh.

This week, market pricing for the terminal rate hit 5%, a threshold Larry Summers aptly described as “kind of a milestone.” Although Daly emphasized that more hikes are necessary just to get policy into restrictive territory, and said rates will rise to between 4.5% and 5%, officials are aware that markets test boundaries. If they (markets) don’t get pushback, they tend to push the envelope even further.

Policymakers are loath to wrong-foot markets unless it serves a purpose. In this case, letting terminal rate pricing get too far ahead would risk a de facto dovish surprise at some point assuming the Fed didn’t meet expectations. That, in turn, could trigger an equity rally to the detriment of the Fed’s inflation-fighting efforts.

Bottom line: If you think market pricing is getting ahead of policy, it’s best to talk it back while you still can, unless you’re sure you want to take what the market is giving you. In this case, it’s possible the Fed doesn’t want terminal rate pricing to drift too far above 5%. Or at least not yet.