US 10s finished the week unchanged, sticking around the seemingly insurmountable range of 1.75-1.8%, while the yield on 2s rose ~10bps, causing 2s10s to flatten back to 80bps, reversing two-thirds of the steepening from the first week of the year.
It was always going to be difficult for the curve to steepen further with spot inflation, (and therefore near-term inflation expectations) as high as it is. What didn't help was a cacophony of Fed (and non-Fed) voices talking 3-4 rate hikes in 2022 (Dimon wants 6 or 7 by the way), further inverting the inflation expectations curve. And last, but not least, positioning! No matter what happens in Rates, can always blame positioning :)
The nomination hearings went as expected with Powell and Brainard both almost pledging to bring inflation back to target, though they expect factors largely exogenous to monetary policy to do the bulk of their work for them this year. As it stands, the latest inflation report wouldn’t have changed their mind about it.
Headline CPI printed 7%, and the increase was broad enough for the Fed to stay on their tightening path, but the impact of Covid was also evident, with a huge gulf in annualized inflation since Feb-20 in Services (2.6%) vs Car & Truck Rentals (24.5%). This mix allows the Fed to begin removing accommodation while waiting for the fiscal drag, the reversal of base effects, and easing supply chain disruptions to slow inflation by the end of this year.
Meanwhile, retail sales missed expectations! The number is now effectively flat since Q1-2021, when spending got a boost from the American Rescue Plan, passed after Democrats won Georgia, and probably lower if we look at quantity instead of value. The number is still significantly above trend, and one could argue this miss was due to Omicron, holiday shopping being brought forward, or lack of inventory. If it sustains beyond January, then questions regarding whether this loss in momentum is just a return closer to the trend, or the beginning of a slowdown will arise.
Back to Fed’s policy, there’s an incredible amount of speculation on when and how the Fed will shrink its balance sheet and how the Treasury may respond to it. So far, the only clarity from the Fed's side has been that it would happen 'sooner and faster' (versus the previous cycle). I think they should announce it by June, and run off $50-60bn in USTs per month. As Powell said, the weighted average maturity of Fed’s SOMA holdings is shorter this time, which means it will take longer for them to unwind it. Therefore one option for the Fed (and even the BoC) would be to follow the BoE - run-off until the policy rate hits the neutral rate, and then start selling bonds?
In other news, the sell-side hawkish bandwagon reached Canada, as well as the EU this week. Yes, that's right, the EU! :) No surprises with them calling for a Jan hike from the BoC, given the data and Oil (which has erased the Omicron dip) though I still think the BoC should wait for the data to confirm what Oil here is indicating. But the EU? Why not I guess - even the BoJ's apparently debating messaging on rate hikes. All this optimism is reflected in USD's weakness, where the rate differential dynamics are no longer incrementally supportive, and reminds me of “synchronous global growth”. Does anyone remember that?
Coming up, we have an important survey from the BoC and CPI which could decide the fate of the Jan meeting. There's unemployment and inflation data in the UK as well, where the BoE is expected to deliver a 25bps hike in February, and Jobless Claims which could help gauge Covid's impact on January payrolls.
The bar for a big move in Whites is high here, 3-4 hikes being an appropriate range for now, though as discussed previously, they can still throw a tantrum and would be forgiven for doing so. If the Fed is proven wrong, and inflation’s second derivative hasn’t turned meaningfully in the second half, the pace of tightening can be increased. EDZ3, 5s, or 0EM2/2EM2 put structures could be interesting here. Probably in the minority with this but given the outlook for Oil, CAD looks cheap-ish and Gold rich if you believe that real rates in the US should be moving closer to 0%. Thoughts?
Thoughts on the Week
We are in transition now. Impulse still pushing through while Fed wakes up to the realities of new supply/ demand dynamics. The Fed reminds me of a novice surfer looking out at the coming wave and wondering how early to paddle and how steep the drop will be. Or they could have just missed the best wave and are looking to see if the next set will be so big that the whole break closes out on them.