Markets are fighting the Fed

It is difficult to overstate the importance of the change in market dynamics that occurred last week. Whilst this is meant to be a forward-looking publication, it is useful to review the market moves and their underlying assumptions, as these will get challenged by this week’s heavy batch of US data and events, and as our US-based readers return from a long weekend celebrating Independence Day.

The US curve prices Fed Fund rate to peak 25bp below our own forecast

The first port of call is the extent of the re-pricing of Fed hike expectations. Unlike their GBP and EUR equivalents, we never thought US swaps had reached ‘Alice in Wonderland’  levels. While both Sonia and Estr forwards still imply a terminal rate roughly 100bp higher than our economists predict, the US curve prices Fed Fund rate to peak 25bp below our own forecast. The peak of the US forwards curve is now December 2022. Longer maturities imply the Fed will quickly have to reverse its late 2022 hikes, and cut in 2023.

Peak Sofr is 25bp below our forecast, peak Sonia and Estr are still 100bps above

Discussions about the magnitude of the June 2022 and future hikes will no doubt be one of the main topics in the FOMC minutes to be released tomorrow. They should also cement the view that the Fed has turned into a backward-looking institution, trusting past CPI readings more than its own forecast to guide it on a potential pivot. This should in theory prevent the market from pricing that pivot before end-2022, but any sign that recession fears are affecting the Fed’s decision-making could bring down even shorter rates. Another weak ISM reading this week could also add to this impression.

A clearer path lower for long end yields

All this occurred even as long-dated inflation swaps collapsed further. Despite this, real rates still led the bond market rally last week, illustrating the market’s recession fears, and widespread scepticism that tight Fed policy can be maintained for a long time. The Fed is unlikely to be satisfied with real rates dipping back towards negative territory, but the further decline in inflation swaps suggests that price dynamics are mostly a short-term concern to investors. So short-term, in fact, that the yield curve has re-steepened, a sure sign that investors see this as a turning point in this cycle.

Price dynamics are mostly a short-term concern to investors

All this is contributing to restore bonds’ credibility as recession hedges. The path lower for longer-dated yields is clearest in our view, as these are less exposed to late cycle-spurts of hawkish rhetoric by central banks. In fact, we might even see long-end rates drop on comments judged too hawkish. We thus suspect their convergence lower will prove more attractive to most investors once accounting for volatility.

Real rates have led the latest rally but the bigger story is the collapse in inflation compensation

In basis points terms, the front-end has the most to adjust. However, the Fed will no doubt labour its hawkish point in the coming months and we wouldn’t discount its ability to still move this part of the curve higher, especially if its message is reinforced by another higher-than-expected CPI print, or by an acceleration in wages in Friday’s job report.

Today's events and macro view

Most PMIs released today in Europe will be second readings, with the exception of Spain and Italy. At a time of resurgence in eurozone sovereign crisis fears, signs of economic divergence will be closely monitored.

Austria (6Y/10Y) and Germany (11Y linker) kick off this week’s sovereign bond supply, albeit in modest size.

US data will ramp up throughout the week, culminating in Friday’s job report. Today sees factory and durable goods orders.

Scheduled central bank speakers are few and far between today, a rarity. The exception will be Silvana Tenreyro of the Bank of England.