Terminal related speculation is the largest driver of USD rates movements at this point. The market is gravitating towards 5%, a level that could be reached in 1Q23 (in line with DBS’s view). While a range of factors determine where the FFR rates would go, we argue that the single largest factor might be where inflation is going to settle and to a smaller extent, where the neutral real rate should be at. On the first point, we think breaking down CPI into the shelter component and the sticky components excluding shelter (as per the Atlanta Fed’s measure) might be more meaningful than looking at the headline figures as the shelter component tends to lag. We also smooth and annualized the figures to get a more accurate depiction on how prices are evolving. Annualized sticky inflation (less shelter) is running at about 5%, down from a peak of around 7.5% in June. Meanwhile, the shelter component hit 8% annualized in September and it remains to be seen if that is the peak.
5% inflation is still uncomfortably high by any measure. With monetary policy impacting with a lag of 6-12 months, it would probably require a similar timeframe to see if inflation eventually gets closer to the Fed’s as yet unrevised 2% target. If we have shifted into a higher inflation regime, the costs of bringing inflation much below 3% might well be prohibitively high, requiring a much higher unemployment rate and possibly much more pain in the financial markets. Uncertainty on what the neutral real rate should also be considered. For much of the past 40 years, real rates have fallen as the inflation threat from the 70s and 80s fade. Over the past 15 years or so, bloated central bank balance sheets have also reduced term premium. Neutral real rates were probably around zero in the post-GFC environment. It might well be closer to 1% in the post pandemic era. Accordingly, we think that term premium should be higher as markets brace for a more volatile, higher inflation world. A long run inflation rate of 3% and a neutral real rate of 1% would put the nominal neutral rate at 4%. Steepening in the 2Y/10Y and 5Y/30Y might be the way to express this view over the coming quarters. 
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