USD rates are finally paring acute fears of a banking crisis. 2Y yields have climbed back into the lower bound of the 4-4.5% range while 10Y yields are now comfortably above 3.5%. There are no obvious fundamental triggers on the turnaround and the vulnerabilities of banking sector remains. Instead, the past week probably marked near-term capitulation in the current episode of banking sector turmoil. With sentiment stabilizing for now, we take a look at the breakdown of USD rates to see what is being priced in and how these fits into still-stressed financial conditions.
First, the Fed path pricing has swung from one extreme to another. At the worst of point of the crisis, the market was pricing in more than 200bps of cuts from peak by end-2024. Some of this has faded. While there no longer is conviction of further hikes (<50% chance priced for May), the number of cuts priced out to end-2024 has fallen to 164bps. There might be further to go if sentiment stays stable. Second, inflation expectations (10Y breakeven) have rebounded from the low to 2.30%. Moves in the long end have generally been muted through this episode. Overall, breakevens still look a tad low. If the Fed now places a greater emphasis on financial stability compared to a month ago, there might be scope for breakevens to climb further, driving long-end rates up in the process. Third, we think term premium is about neutral. Extreme pricing of stagflation (inverted curves) has faded.
If sentiment stabilizes, the Fed will toe the line between financial stability and inflation risks. This will mean limited room for a higher terminal rate than what is already guided. Instead, the bias would be to assess the economic damage, keep rates steady for some time before guiding policy settings back towards neutral when inflation comes under control. Meanwhile, market participants will likely be wary of financial system risks, keeping a premium on the front and belly of the yield curve as a recession hedge. We suspect that the 4.3-4.5% area would prove a tough resistance for the 2Y tenor. Curve wise, we still prefer tactical steepeners in the key segments (2Y/10Y, 5Y/30Y and 2Y/30Y), noting outsized payoffs if a hardlanding takes place.
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