USD Rates: Painfully hot inflation
The latest reading on US CPI is unwelcome to say the least. Headline and core CPI both beat consensus estimates, hitting 0.4% and 0.6% respectively. Much of this appears to be driven by sticky services inflation including the shelter component while goods inflation appears to moderate. Alternative measures such as Cleveland Fed’s trimmed mean measure and Atlanta Fed’s sticky CPI also point to elevated levels of price increases. The only silver lining is that our measures of sequential inflation (which takes into account non-seasonaly adjusted indices) suggests that CPI momentum is falling somewhat. In any case, there was a sizable negative reaction in the fixed income space. 10Y UST yields, which were trading below 3.85% before the data release, popped as high as 4.08% before reversing a chunk of the gains to close at 3.94%. Meanwhile, 2Y yields rose by an even larger magnitude, touching as high as 4.53% on an intraday basis. With reference to our forecasts, 2Y yields are just short of our projection of 4.7% while 10Y yields have already exceeded our target of 3.90%.
Between the strong labour market figures released last week and still too-hot inflation, data is not allowing the Fed to downshift. However, there are other considerations even as the Fed has become a lot more data dependant. The tightening in real rates thus far in this cycle is unmatched over the past 40 yearand the lagged impact of monetary policy should be considered. This point could be even more important when the Fed gets to 4.5% (75bps and 50bps in the next two meetings with some upside risks) by end-2022. Note that the Fed’s long-run neutral rates is kept at 2.5%. A real rate of 2% is clearly restrictive and there will probably be a need for some time to wait out the effects of restrictive monetary policy. We would argue that risks of a disorderly worsening of financial conditions should prompt a Fed downshift (a slower pace of hikes), by end-2022/early 2023 even if data continues to hold up. Strategy wise, we remain in the receive on spikes camp for 5Y and 10Y yields and see risk reward to be favourable when financial conditions are showing considerable stresses. Curve wise, we are still biased to curve flattening as inflation stays sticky near-term prompting the Fed to keep rates elevated. We reckon that 5Y yields would be the key beneficiary when the Fed eventually downshifts and see receive 2Y/5Y/10Y fly as a decent way to express this view.
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