I have some potentially distressing news for those who might’ve gone all-in on the notion that the Fed wouldn’t (or couldn’t) make good on the promise implicit in the last dot plot: Terminal rate pricing has moved markedly higher.

In fact, it’s one full 25bps increment off the bottom of the range established in October, when a tenuous agreement on something in the neighborhood of 5% helped rates vol recede, setting in motion a rally in stocks and bonds, and a dollar swoon which, when measured on a 12-week rolling basis, was virtually unprecedented through early last week.

Of course, we’ve seen a series of favorable inflation prints since October too, and a deescalation from the Fed in the pace of hikes. The paradox for policymakers is that early signs of disinflation (e.g., in goods, new leases, etc.) and the step-down in hike increments arguably sow the seeds of their own demise to the extent markets front-run a soft landing by grabbing into stocks and pushing yields lower. That eases financial conditions and acts to offset Fed tightening.

If that’s counterproductive, then a stronger dollar and firming terminal pricing is a sign that markets are behaving more rationally. “The good news is that I think markets are already behaving far more rationally now even just versus a few days ago, and we see new pricing across the board in the rates / USTs / duration space, as terminal [pricing] moves higher and further out [while] that legacy ‘imminent 2023 hard landing recession’ probability gets REKT and pushed into 2024,” Nomura’s Charlie McElligott said, in a Monday afternoon note.

Note that the same dynamic was readily discernible in the curve, which bear flattened fairly sharply to start the week into this newfound respect for the Fed’s “higher for longer” narrative.

This is “rightfully altering the probability distribution for late 2023 / early-2024 pricing, while also forcing unwinds out of some ‘dovish’ tactical trades, which is contributing to the magnitude of today’s moves,” McElligott went on.

The intraday visuals are instructive here. On the left is the repricing in terminal rate expectations.

On the right is the 2s10s. Twos were cheaper by 15bps on the day.

This came on the heels of last week’s scorching payrolls headline and ahead of a cacophony of Fed speakers, including Jerome Powell, who no doubt noticed loud jeers from critics last week, when he inadvertently triggered a meaningful extension of recent financial conditions easing by “failing” to scold stocks for having the nerve to rise after the worst year since Lehman.

McElligott on Monday reiterated the main points behind his “most mispriced tail risk” thesis, but he wasn’t suggesting the price action represented wholesale buy-in. Rather, his point was that markets appear to be coming around to the idea that the US economy isn’t going to fall off a cliff, and that the rekindling of animal spirits on the back of the rally in stocks and bonds has the potential to keep things running too hot for the Fed’s liking.

If that’s the case, the Fed is very likely to remain committed to getting rates above 5% and keeping them there, but more than that, officials may begin to entertain the idea of a possible resumption of hikes down the road — say, if there’s no evidence of disinflation in the collection of categories that together comprise “services ex-housing.” Rates aren’t priced for that. At all. And neither are stocks trading at 18x inflated earnings estimates.

It’s not surprising to see some of that mispricing start to correct in rates. Charlie went on to write that “the global data re-acceleration is enough to potentially offset the ‘smooth disinflation’ glide path meme, which in and of itself is why people were not taking a Fed ‘higher for longer’ path at face value — but maybe now they will, as the path remains uneven with two-sided risk.”

He also weighed in on the Phillips curve debate. “The Fed will need to tilt ‘higher for longer’ until they see their favored Phillips curve exert some semblance of impact on labor.”