The net change in US 10y yields or S&P 500 may not indicate this, but a lot happened this week. Markets were expecting the Fed to walk back on the recent pivot in response to the correction in stocks and the BoC to hike rates. None of that happened.
The thinking around Fed’s policy trajectory going into this meeting was that rate hikes this year are meant to keep inflation expectations in check while the Fed waits for inflation to ‘naturally’ decline by the end of this year. This meant that the Fed was expected to lift rates gradually, three or four times this year.
However, Powell’s ‘a lot of room to raise rates without denting the labor market’ and ‘this is a different situation’ comments - and not his unsurprising reluctance to rule out 50bps or consecutive hikes - introduced genuine upside risks to the gradual lift-off view. As a result, the market’s now pricing nearly five hikes in 2022, three of which could come in the first half.
Of course, the path of rates will ultimately depend on how inflation actually evolves, but data dependency, lack of respect for forecasts and risk management, three of Powell’s favorite guiding principles, all justify a frontloading of hike expectations as inflation is more likely to remain high in the near term. This invariably leads to a flatter curve and a shorter hike cycle, though the market is reluctant to price a higher terminal rate.
Another surprise was the release of Principles for Reducing the Size of the Federal Reserve's Balance Sheet. While the release was scant on details, it did express their desire to hold a Treasury-only portfolio eventually, which indicated that they might be open to either selling MBS or reinvesting proceeds from MBS run-off into Treasuries. Powell went on to clarify that they would need at least another two meetings to finalize the deliberations. Accordingly, I expect them to announce the run-off in June, such that it can begin in July. One thing that remains unclear is whether QT can ever substitute rate hikes or is supposed to play a supporting role. In my opinion, given the Fed’s less certain of the impact of QT on financial conditions, they are likely to continue with changes to the policy range as the main tool as long as inflation remains a concern. Lastly, they said they want to maintain just enough reserves needed to implement monetary policy efficiently in an ample reserves regime. But how does anyone arrive at the figure?
Up north, as expected, the BoC didn’t raise rates, despite the market pricing ~70% odds of a hike going in. They cited Omicron, and the need to be deliberate to delay lift-off till March. Truth is, Fed’s pivot obscured the market’s read on BoC’s well-telegraphed reaction function. The decision to wait despite an upward revision in the Q4 2022 inflation projections and an admission that slack has been absorbed led to questions on whether their credibility as an inflation-fighting central bank has been hurt. Not much in my opinion, since their ‘interest rates will rise’ message means the rates that actually matter for the broader economy, such as the 10y real yield, is not very far from pre-Covid levels.
Moreover, with nearly six rate hikes priced in 2022, this may not be the last time the BoC under-delivers market expectations this year. While BAX has been perpetually oversold market, given that both the BoC and the Fed have promised to begin hiking rates next month, forwards have some room to converge.
Looking ahead, we have another loaded week with the BoE, the ECB, and the RBA scheduled to inform us of their latest thinking on inflation. The BoE is expected to raise rates by 25bps. Though one can never tell with them, they don’t seem to have a choice given how sticky the market-implied inflation measures are proving to be. Other than the hike itself, it would be instructive to see BoE’s inflation projections based on the current rate path of ~120bps in hikes this year, which could indicate what they think about the pricing.
The RBA, if you believe the Street, will be making the biggest about-face in history this week, with some expecting a sudden stop to QE in February and a hike in May or August itself after the CPI beat. Market’s are pricing nearly four hikes this year while RBA Governor Lowe continues to suggest that rate hikes could come as late as 2024.
Market’s lack of respect to central bank guidance is visible in the EU as well. While they have a clearly listed plan of buying bonds until September (which rules out hikes), with EUR20bn in PSPP to continue after that as long as necessary, record-high EU inflation and the hawkish set up in fronts globally have dragged markets lower in Europe as well, such that Bunds briefly witnessed life on the other side of 0% and Euribor fronts are pricing more hikes than (almost) ever. With no projections to be released next week, expect Lagarde to not answer anything clearly enough to cause a reaction in the market :)
Last, and definitely not least, we have the US Treasury Refunding announcement, where the Treasury will announce auction sizes and projections for Bills and TGA. General expectations from the Treasury is to cut coupon sizes as they are likely to be overfunded at current sizes with respect to the deficit plans. However, given the ‘faster and sooner’ timeline for QT, the Treasury may have to slow or stop cuts to coupons to repay the Fed, unless they want to use bills as a way to use the excess cash parked in RRP. Whether they choose to go with smaller coupon cuts or larger cuts with increased bills issuance would determine which part of the curve cheapens versus OIS, by influencing the net supply of duration to the private sector.
For next week, the expectation is for a $2bn cut to most tenors except 7s and 20s, which should see larger cuts and no cuts to TIPS. The increased supply of TIPS and Fed’s hawkish pivot should combine to push real yields higher in the coming months. The risk to this view is if the momentum in data, which the labor report this week should confirm is slowing, doesn’t turn and we end up in a recession of sorts, or the Ukraine-Russia conflict finally escalates.
Nice work Rishi. I reckon if the Fed really wants to know where the minimum amount of reserves is all they have to do is stop paying IOER, drop the rate on RRP to their policy floor and let the banks dump any excess in RRP. Pretty sure the banks with get rid of any reserves they don't need if they're not paid to hold them in quick time.