Inflation became the clear and predominant economic theme in October amid stubborn supply chain issues and emerging wage pressures
Fixed income markets are now pricing a much more aggressive Fed rate hike schedule for 2022-2023, including two 25 basis point hikes next year
Bond markets have put global central bank leaders in a difficult position, and future communication by monetary policymakers will be even more closely scrutinized
If there was any question about what the predominant economic/market theme was heading into October, it was clearly affirmed by the end of the month. Inflation has been a hot topic ever since the global economy began to reopen earlier this year, fueled by pent-up consumer demand and trillions of dollars of fiscal and monetary stimulus. Up until this point, the position of the Fed has been that any rise in consumer prices would mostly likely be transitory and, therefore, not require an immediate policy reaction from the FOMC. The bond market, in general, extended credibility to the Fed’s stance, even as multi-decade high core inflation readings emerged starting in April. Following the initial Treasury curve steepening of the first quarter, Treasury yields traded in a relatively tight range, and market inflation expectations, as measured by TIPS breakeven yields, actually subsided beginning in mid-May (after the release of the April CPI report).
As the summer rolled on, concerns over growing global supply chain issues moved to the forefront of the news cycle. At the same time, the labor market continued to tighten, fueling wage inflation worries. September policy meetings by the Fed, European Central Bank (ECB), and Bank of England (BoE) were all generally perceived as more hawkish, which fueled an upward shift in Treasury yields across the curve. This rise in Treasury yields coincided with a repricing of short-term rates in anticipation of the Fed having to act sooner on rate hikes to combat inflation. Exhibit 1 tracks the forward curve for 1-month OIS contracts as of October month-end relative to the day before the September FOMC meeting. The market is now pricing two 25 basis point rate hikes in 2022 and four rate hikes by the middle of 2023. This is a sharp change in expectations for the next 18-24 months and helps explain the 28-35 bps increase in 2-year and 5-year Treasury yields over that timeframe.
Market speculation over what the Fed and other major central banks will have to do from an interest rate policy (IRP) perspective has fueled a series of curve “twists” over the last several weeks, primarily pivoted around the 7-year part of the yield curve as the bond market prices for policy error. If the Fed does have to act sooner and more aggressive than it would like, as the market is projecting in Exhibit 1, it would not only work to suppress inflation pressures, but could also stifle/slow the economic recovery. As such, the 2-year/10-year Treasury yield spread two years forward flattened 15 bps in October to late 2017 levels, when the Fed initiated balance sheet normalization efforts following the last easing cycle (see Exhibit 2). In short, the bond market is pricing for more persistent inflation, even if central bank leaders haven’t conceded such.
Cornering the Fed?
Is the market effectively backing the Fed into a corner? Remain dovish and act later on rate hikes, and the Fed risks more severe bond market tantrums, sending yields higher and threatening the current recovery. Get hawkish and act sooner on rate hikes, and risk markets (e.g., stocks) could suffer on diminished economic growth expectations. It’s not an ideal position for Fed Chair Powell and his global peers. During her October 28 press conference, ECB President Christina Lagarde attempted to push back on the recent bond market pricing of more hawkish IRP in the next year, but it wasn’t effective. The FOMC meets on November 3, and in addition to an anticipated announcement of QE tapering, market participants will be looking for any small adjustments to the inflation guidance in the official statement.
Powell will also be challenged to convey credibility via effective communication in his press conference following the meeting.
We wouldn’t be surprised if Powell chose not to push back on recent bond market pricing, just as he and his colleagues remained largely silent on that front during the Q1 curve steepening. However, he could still reiterate that the bar for liftoff remains high.
While the market is speculating that inflation will be more persistent, Fed forecasts as of the September 22 FOMC meeting suggests otherwise. The minutes of that meeting revealed that the Fed’s Washington-based staff forecasted that inflation will be back below 2% in 2022, less than half of the September PCE year-over-year rate of 4.4%. A Bloomberg article on October 18 touted the past prowess of this Fed staff of more than 400 Ph.D. economists relative to private forecasters according to studies conducted by the St. Louis Fed and others. While forecasts are always limited given an inability to accurately predict the future (don’t we all wish!), the Fed has been better than most given unmatched resources relative to private firms.
The moral of the story is that there are an abundance of factors impacting rates along the yield curve, all of which are based on forecasts of future events. It is helpful to have a better understanding of what assumptions are being priced at any given time, at least as much as it can be clearly discerned. However, attempting to speculate on such rate/market changes is a difficult, if not impossible, strategy to repeat over a long time horizon, and attempting to do so makes little sense for investors with liability-funded portfolios.
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