A key factors we look at as we gauge the level of policy restrictiveness would be implied real yields. Implied 1Y and 2Y real yields are now above 3.2% and 2.3% respectively, extremely tight if we assume that neutral real rates should be in the 0.5-1.0% area. Note that these real yields are also close to cycle highs and have picked up significantly over the past two months as banking sector worries abate. Interestingly, the broader market has been resilient (seemingly mirroring that of the real economy). Despite the surge in short-term real yields, financial conditions are not stressed. Looking at the performance of the stock market and credits space, it feels more like a risk-on environment.
We are hesitant to interpret the markets in that straightforward a manner. To be fair, it could well be that the economy and the markets can now withstand a much higher real rate. This would be a benign scenario, but this would only be one of several possibilities as we mull the coming few quarters. An offshoot of this idea is that there was no meaningful rise in implied 10Y real yields for a few quarters. If assets are now more sensitive to this rate, it could explain why financial conditions have been more stable. Another possibility would be that breakevens are underestimating how high inflation could be. If breakevens rise without a commensurate increase in nominal yields (a big assumption), implied real yields would fall automatically. It could also well be that markets have not quite figured out what the next big narrative would be and pricing across markets have become inconsistent. We don’t think there is a clear answer at this point. Looking out the next two weeks, the best-case scenario for risk would be weak CPI print, allowing the Fed to stay relatively dovish. The Fed might then opt to pause and perhaps put just one more hike in the dotplot for optionality. A firm CPI figure would almost certainly lead to a rise in both nominal and real yields, perhaps pushing monetary restrictiveness to the threshold where risk takes a tumble.
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