USD Rates: Explicit acknowledgment of recession risks

Our terminal US rates remain at 3.50%
Group Research, Eugene Leow23 Jun 2022
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    The focus of the market is once again tilting towards recession risks with 10Y US Treasury yields tumbling below 3.20%. While pricing has oscillated several times between inflation and recession fears this year, Fed Chair Powell gave the most explicit hint last night that engineering a soft landing could prove “very challenging.” There are several warning signals that we are watching. First, financial conditions have been moderately stressed as asset prices correct. A prolonged period of market stress tends to foreshadow slower economy activity ahead and this development is once again capping US yields. Second, stresses in the mortgage lending space are showing up as weak housing data. Wide mortgage spreads have not eased meaningfully. Third, there are increasing signs (including rising jobless claims and retrenchment headlines) that the labour market might be weakening. Lastly, 10Y breakeven has fallen closer to 2.50% (within the Fed’s margin of error) suggesting that inflation expectations are still anchored and are perhaps now dampened by higher real rates.

    We remain unconvinced that the Fed would have to hike very aggressive towards 4% in 2023 only to cut sharply thereafter. It might make more sense to hike at a more moderate pace towards our forecast terminal rate of 3.50% and reassessing thereafter. As per our adjusted Taylor rule model, if the unemployment rate rises to 4.5% and inflation cools to 3%, the appropriate Fed funds rate should be 3%. Inflation is the dominant worry for now, but that could change if growth concerns come to the fore. The calculus for policy could shift in the coming months. The US economy is already buffeted by high inflation (a chunk of which is supply side driven). Compounding inflation stress by hiking rates aggressively might not be the path of least regret for the Fed, especially since there are some warning signals already. The Fed might well reduce volatility in the market by downshifting its rhetoric later this year. We think receiving 2Y/5Y/10Y fly might be a decent way to express our view. Curve wise, we think that the 2Y/10Y segment might hover in the zero to 20bps range.

    Eugene Leow

    Senior Rates Strategist - G3 & Asia

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