USD Rates: Inflation still too hot for the Fed to downshift
August CPI data was too hot for the markets, precipitating a major selloff. Headline inflation dipped to 8.3%, but consensus was expecting a larger fall to 8.1%. Sequentially, the 0.6% MoM sa increase in core CPI is worrying (with services inflation accelerating) and more than offsets the decline in energy prices. This triggered another round of adjustment across USD rates. We had recently shifted up our terminal rate forecasts to 4% this year on the back of firm labour market data. With CPI proving sticky, the risk of the Fed extending the rate hike cycle into 2023 is considerable. This would also imply a higher terminal rate than what we currently envisage. USD rates are now pricing in a Fed funds rate of 4.25% by end-2022 (75bps, 75bps, 25bps for the remaining three meetings). Decent odds of a 4.5% peak early 2023 is also reflected. Overnight, our 2Y and 10Y yield targets of 3.60% and 3.45% got hit.
The mix of factors has become challenging for the market again. While resilient growth and slowing inflation can make for a better risk taking environment, the US economy now looks too hot still. With no clear signs of the labour market slowing and inflation still problematic, a downshift from the Fed looks set to be delayed again. With rates staying volatile, we would flag a few points. First, short-dated break-evens spiked to account for inflation possibly staying more elevated than expected. 2Y break-evens are now back at 2.40%, from a recent low of 2.17%. Longer-dated break-evens are largely unchanged. Second, the odds of recession rose as the curve inverted further post CPI release. If the Fed goes as aggressive as priced and 10Y yields stay anchored, the odds of a recession in 2023 would well be in the 40% range. Third, stresses are rapidly building again (especially in the stock market). Implied real rates are now in restrictive territory (close to 1%) across the different tenors. Attention will shift to next week’s FOMC meeting where the economic projections and dot-plot will be closely scrutinized. We would like to flag upside risks to our USD (SGD and HKD) rates forecasts, noting that the hot CPI print might reset the countdown to a Fed pause and also lead to a higher terminal rate than we currently expect.
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