When you hear the term “disinversion,” you probably think Treasury curve.
If this were a normal cycle, we’d be talking a lot about the bull steepener right now — the market would be in the process of ferreting out signs of a looming recession, the front-end would rally in anticipation of eventual Fed cuts and the curve would steepen. Instead, we’ve spent time in recent weeks fretting over a disconcerting bear steepener — the long-end has lost its anchors and looks more like a volatile penny stock all the time, while the front-end’s anchor (the Fed) is obstinate in the face of strong data.
But the most important disinversion may be in SOFR spreads, and particularly in pricing for 2024 rate cuts. That’s where you can observe the evolution of market buy-in for the Fed’s “higher-for-longer” mantra.
“Market implied US rates expectations for 2024 have now removed ~95bps of previously-priced Fed cuts since mid-summer,” Nomura’s Charlie McElligott wrote, in a Thursday note, noting that the relevant spread “made its end-of-day max low at -162.5bps on July 13,” but thanks to the ongoing resilience of the US economy, it’s now in the mid-60s, indicative of trader capitulation into the Fed’s narrative.
The “incredibly persistent de-inversion trade,” as Charlie described it, is “at the core of the move higher in equities implied vol.” The figure above illustrates the point.
Do note: This comes even as terminal rate pricing (so, “How high?” as opposed to “How long?”) has been unchanged for months. Despite beat after beat from NFP, retail sales and so on, “the market refuses to do anything more than extend ‘high-for-longer,’ as participants believe the Fed’s recent messaging switch, stating that we are now at the point in the cycle where the late-stage tightening of US financial conditions and term premium ‘add’ will do the rest of the work for them,” McElligott went on.
In addition to driving equities implied vol, the ongoing pricing out of Fed cuts in 2024 is also behind the expansion in vol-of-vol, Charlie said.
The annotations in the figure above are McElligott’s.
And yet, at the end of the day, the SOFR curve still tips at least two 25bps cuts next year, with some odds of a third. The nuance behind that pricing is important.
“To me, it really continues to look like a bimodal probability distribution, where sure, say 85% we remain ‘high-for-longer’ but with a 15% chance of a 250bps-type cut in the case of a hard landing shocker, because as I keep saying, ‘high-for-longer’ only increases the certainty that when the slowdown does eventually happen, the ‘landing’ will be that much harder,” Charlie said, noting that credit folks tend to agree with that assessment.
