- Forward-looking inflation measures show clear declines.
- Greater Fed recognition that accelerated tightening might cause further financial stress…
- …and aggravate slowdown worries.
- We stick to our view that the Fed will be done with tightening this year.
- Interest rates volatility should start to settle in the coming few months.
Commentary: Peak inflation, peak Fed action and peak Fed hawkishness
We think that the market may have / or are about to crest the three peaks – inflation, Fed action and Fed hawkishness. The runaway inflation / Fed tightening theme has had a good run. While backward looking indicators such as the CPI (9.1% YoY in June) point to elevated price pressures, the forward-looking ones including breakevens and the U Michigan’s survey of inflation expectations show clear declines. This is probably not surprising given the sizable drop in commodity prices and the easing of supply chain woes. Accordingly, while headline CPI figures are still elevated, there are clear signs that inflation would slow ahead. Peak inflation fear is already behind us.
We wonder if peak Fed action and peak Fed hawkishness might also be upon us. The Fed ramped up to 75bps at the previous FOMC meeting. With CPI still running hot, market participants were speculating if 100bps might be on the cards in July. Interestingly, several of the more hawkish participants poured cold water on going even more aggressive. There is perhaps a greater recognition that an accelerated pace of tightening might cause further financial stress, which might aggravate slowdown worries. The 2Y/10Y segment of the curve is already deep in inversion, signaling that the Fed might be oversteering and could perhaps need to U-turn as soon as 2023.
We stick to our view that the Fed will be done with tightening this year, taking the terminal rate to 3.50%. We doubt there is much runway to hike rates beyond this year. By not going too aggressively this year, it would also lessen the chances of rate cuts in 2023.
Overall, we think that interest rates volatility should start to settle in the coming few months. As rates become more “boring”, there could be interest to take on more risks (credit, equities, EM) as a more benign investing backdrop starts to take shape.
Rates strategy wise, we had already pivoted to a receive on spike stance, especially on the 5Y and beyond tenors. For the 10Y tenor, we think that levels stretched above 3% might be attractive. There may be interest to fade the rate cuts priced into 2023 if recession risks recede. There may also be receiving interest in the belly of the curve (5Y) once rates volatility settles and the market is more comfortable with the Fed’s forward path. We still see receive 2Y/5Y/10Y fly as an idea capable of weathering a wide range of scenarios.
Eugene Leow
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