Happy New Year guys! Hope you had a good break because it seems like the market isn't going to give us much time to relax this year. Dramatic first week! It's important to not lose perspective. So let's take a step back.
It all began with Powell, at the end of November, hinting at a faster taper and dropping 'transitory' from the Fed's statement after the blowout CPI print, followed by the median projections for 2022 rising to 3 hikes in December. This, by itself, should have been hawkish enough for the market. However, we were dealing with some uncertainty around Omicron, and there were no other hawkish catalysts left for the year, which led to a bid in rates, as positions were cleared ahead of the holidays.
They returned this week and decided to put some of that risk back on with Omicron largely being considered macroeconomically insignificant (as the price of Oil and the data from South Africa and now London would indicate though we are still not sure how China deals with it). This got the selling (in rates) going, which was helped further, by the sizeable corporate issuance (January is usually busy) led by Financials. Then came the minutes! The key point was the Fed would begin shrinking the balance sheet soon - and by soon, they meant this year, probably after a couple of hikes. This was the final act of the play that had begun with Powell's testimony!
In this light, the repricing has been fair. The prospect of QT beginning in June or Sep has completely changed the net supply assumptions for 2022, which along with Fed's desire for a long, gradual hike cycle, made possible by punctuating hikes with balance sheet normalization, has helped re-steepen the curve. Markets should price in 3-4 hikes for 2022 as long as inflation doesn't dip materially, and there's room for reals to rise given household finances, a hot job market, and a relative increase in TIPS issuance. I believe the long-run real neutral rate for the US, while lower than in previous cycles, is a lot closer to 0 than the market indicates, despite the rise in debt.
Lord Zoltan argued for a 35bps increase in IOR (to go with a 20bps increase in RRP) to widen the RRP-IOR corridor to 25bps, the way it was back in 2016, if and when the Fed decided to move. While I agree with RRP being raised (only) by 20bps to the bottom of the target range, I don’t see why it’s necessary to pay 10bps extra on 3.8 trillion in reserves to banks. Nonetheless, markets agreed that SOFR-FF spreads would widen in 2022, as the RRP-IOR corridor would at least widen by 5bps.
In other markets, CAD-US spreads have corrected and Bunds are close to 0 thanks to this move in US rates. I still believe US markets have not thrown any tantrums so far, which is perhaps something to be wary of if one is looking to fade Whites - perhaps sell some EDZ2 puts? Though fading BoC March hike odds and CHF receivers might be the real opportunity.
Next week we get CPI, which is expected at 0.5% on the month. Those with steepeners would be hoping for a weaker print. I am looking forward to Powell and Brainard for any clarity on the pace of QT and the eventual size of the balance sheet. FOMC participants showed a lot of optimism around the Standing Repo Facility as being a solution to managing the policy rate in an ‘excess but not excessive’ reserves regime, though the design has several holes and might not work the way think it should. 3s, 10s, and 30s should provide an option for real money to buy in, though we could also get huge tails like Feb 2021. While the 1.77 level in 10s is sticky, might not want to buy bonds until they write about convexity hedging :)
Thoughts?
Nice work! I totally agree with your idea that the market’s estimation of R* is way too low. I would add that most of the issue is the level of 5y5y OIS. I can’t really argue with 5y5y inflation at ~2.5%.