In the week just past, the Treasury market sold off in a rather dramatic fashion and we saw a couple key benchmark curves invert along with the significant flattening. The week also saw an impressive market reaction to Powell’s Monday morning speech in which he more resolutely laid out the case for a 50 basis point rate hike in May and maybe even in June as well. And when the Chair was asked, “What could prevent the committee from going 50 in May?” he gave a very clear answer in, “Nothing.”
Beware of Overoptimism in Equity Markets
Clearly, the rate markets have priced to a more aggressive policy rate normalization path because if we get a 50 basis point hike in May, we’re certainly going to price in a 50 basis point hike in June, as well as the realities of the balance sheet runoff, which is expected to be announced as early as the May FOMC meeting. While at the same time, equities have managed to hold in remarkably in such an environment. The fact that the S&P 500 returned to 4,600 to me does reflect a great deal of investor optimism, which I think is worth exploring in a little bit of detail in today’s blog. All else being equal, I would have expected Powell’s hints at a 50 basis point hike in May to have had a much more meaningful impact on stocks.
The traditional narrative is anything that monetary policy makers do to curtail inflation comes at the expense of growth and eventually the jobs market. Unlike most of the central banks in the world, the Fed has a dual mandate, which is to promote both price stability and full employment. So, as we have seen, this created a unique set of challenges for the Fed during this particular cycle. What Powell has done is he has reframed the impact of inflation on the employment market. Specifically, the Fed’s mantra now is that price stability is key for continued hiring. By effectively recalibrating market participants’ expectations for what “a good policy response” would be, the FOMC has created a trading environment in the equity market in which everything that is hawkish but ends up being risk-on simply because Powell and the Fed are now aggressively fighting what has been identified as the biggest risk to the real economy. However, that doesn’t mean that an extreme hawkish fed and tighter monetary policy won’t ultimately curtail growth, but for the time being the equity market is trading it as such.
The question is, when will the optimistic equity investors eventually realize it? In practical terms, if we start to see a more meaningful hit to earnings with the backdrop of higher borrowing costs that’s going to create a more significant repricing in risk assets. And being aware of this potential earning risks, investors and traders will hedge their positions ahead of the release. A two-week window sounds very reasonable to me.
Key Benchmark Curve Inversion
In the past week, we have also seen a couple key benchmark curves in the Treasury market invert, notably the 5s-10s dipped below zero for the first time in the cycle, which is very consistent with what we’re seeing in terms of the flattening of the yield curve. We saw 2s-10s below 20 basis points and 5s-30s the flattest than it’s been since 2007. Now, for context, one of my convictions for this year has been a flattening of the yield curve to the point of inversion in 2s-10s. Now, my baseline assumption is that 2s-10s will eventually invert sometime between now and the May FOMC meeting. If and when this occurs, the bigger question will quickly become, how far can 2s-10s invert given that it’s occurring much earlier in the cycle than we would have otherwise expected? Well, the lower bound historically has been roughly negative 20 basis points.
3M-10Y/2Y-10Y Divergence
One interesting aspect of the flattening we’ve been seeing is that there are two key measures of the yield having veered in opposite directions. While when we think about the shape of the yield curve and what it implies for the performance of the real economy, the market investors tend to focus on the 2s-10s spread, but the Fed research supports the idea that the most relevant curve is three-month bills versus 10-year yields, which currently stands at roughly 188 basis points. Some may argue that the divergence is sending mixed recession signals, but the caveat there being that three-month bill yields tend to move lockstep with policy rate. So, if we do see 50 basis point rate hikes in May and June, that will get that spread to 88 basis points, to say nothing of the fact when the Fed starts to unwind SOMA. The incremental supply in the bill market will push rates even higher, contributing to further flattening in three-month bills versus 10s. So my base case is that the 3M-10Y curve will soon begin to flatten as the tightening policy that the Chair has laid out unfolds in May and June.
Headline Inflation Set to Stay High
We also got the 10-year TIPS reopening last week, which tailed 1.8 basis points. Analysts think it’s fair to characterize the result as decent. But what really interests me is, what does that strong demand for inflation protection at this moment in the cycle mean to the inflation outlook, especially given the increasingly hawkish Fed backdrop that we’ve been talking about?
Obviously, the market participants believe that there are types of inflation that will not be responding to the tighter Fed policy, to which I feel very sympathetic. All in all, the Fed doesn’t pump oil and the Fed doesn’t grow grain. A higher Fed funds target band is going to do little to alleviate the pressure in the oil market, or the upside in food prices that are resulting from the disruptions in Europe and the role that Ukraine plays in global food supply chains. So, even if the Fed is able to effectively combat rising core inflation, it’s not unreasonable to assume that we’re going to see higher headline inflation for a little bit longer timeframe. And in this context, given the fact that TIPS are linked to headline CPI, it was telling me that we saw good auction demand, despite a Fed that is clearly committed to do what it can to contain higher consumer prices.
All About Macros 